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TelenavUltimate Software 2000 Ultimate Way Weston, Florida 33326 800.432.1729 954.331.7000 www.ultimatesoftware.com selected financial data operating data in thousands, except per share data for the years ended december 31, 2 0 0 4 2 0 0 3 2 0 0 2 revenues: recurring services license total revenues gross margin as a % of total revenues operating expenses and other as a % of total revenues $39,049 24,924 8,055 $29,344 23,478 7,594 $19,345 23,634 12,170 72,028 60,416 55,149 40,626 56% 45,650 63% 32,837 54% 42,006 70% 27,621 50% 42,189 77% net loss $(5,024) $(9,169) $(14,568) diluted net loss per share (1) $(0.23) $(0.49) $(0.90) (1) See Note 2 of the Notes to Consolidated Financial Statements included elsewhere in this Annual Report for information regarding the computation of diluted net loss per share. balance sheet data in thousands as of december 31, 2 0 0 4 2 0 0 3 2 0 0 2 annual meeting cash and cash equivalents $14,766 $13,783 $8,974 investments in marketable securities total assets deferred revenue long-term debt, including capital lease obligations, net of current portion 10,544 52,546 28,476 – – 35,812 31,143 24,610 27,815 1,231 796 1,206 stockholders’ equity (deficit) $13,524 $1,661 $(7,368) independent registered public accounting firm investor relations company profile Ultimate Software, a leading provider of Web-based payroll and workforce management solutions, markets award-winning UltiPro as licensed software, as a hosted application through Intersourcing, and as a co-branded offering to Business Service Providers (BSPs) under the “Powered by UltiPro” brand. The Company employs approximately 450 professionals who are united in their commitment to developing trendsetting solutions and delivering quality service. Ultimate Software customers represent diverse industries and include such organizations as Benihana Restaurants, The Container Store, Elizabeth Arden, Omni Hotels, Ruth’s Chris Steak House, SkyWest Airlines, and Trammell Crow Residential. More information on Ultimate Software’s products and services can be found at www.ultimatesoftware.com. UltiPro and Intersourcing are registered trademarks of The Ultimate Software Group, Inc. All other trademarks referenced in this report are the property of their respective owners. Chairman, President, and Chief Executive Officer Vice Chairman and Chief Operating Officer board of directors Scott Scherr Ultimate Software Marc D. Scherr Ultimate Software James A. FitzPatrick, Jr. Partner Dewey Ballantine LLP executive officers Scott Scherr Chairman, President, and Chief Executive Officer Marc D. Scherr Vice Chairman and Chief Operating Officer LeRoy A. Vander Putten Executive Chairman The Insurance Center, Inc. Robert A. Yanover President Computer Leasing Corporation Rick A. Wilber President Lynn’s Hallmark Cards Mitchell K. Dauerman Executive Vice President, Chief Financial Officer, and Treasurer The annual meeting of stockholders will be held on Tuesday, May 17, 2005, at 10:00 a.m. EDT at 2000 Ultimate Way, Weston, Florida. Formal notice will be sent to stockholders of record as of March 18, 2005. annual report and form 10-K A copy of the Company’s 2004 Form 10-K filed with the Securities and Exchange Commission, which is provided in this Annual Report, is available without charge upon request to: Investor Relations Department, 2000 Ultimate Way, Weston, Florida 33326. KPMG LLP Miami, Florida legal counsel Dewey Ballantine LLP New York, New York transfer agent and registrar EquiServe Trust Company, N.A. P.O. Box 219045 Kansas City, MO 64121-9045 877.282.1168 www.equiserve.com For additional information about Ultimate Software, contact Mitchell K. Dauerman, 954.331.7369 stock trading Ultimate Software’s common stock is traded on the Nasdaq National Market under the symbol ULTI. company address Ultimate Software 2000 Ultimate Way Weston, Florida 33326 800.432.1729 or 954.331.7000 www.ultimatesoftware.com 1 Intersourcing: more than an innovation – a transformation Our hosted service model is giving companies a new way generating primarily license revenues to a hybrid financial of outsourcing their human resources and payroll needs. model with some license revenue and a higher percentage Providing them on-demand services. Making UltiPro a of recurring revenues. smarter choice than ever for organizations across all industries. And generating more consistent recurring For our customers, Intersourcing means convenience with no revenue for our business. loss of control. They have Web access to the comprehensive, award-winning functionality of UltiPro, with the added benefit When Ultimate Software decided to offer its customers the of Ultimate Software providing the hardware, technology option of using the UltiPro Workforce Management product support, product updates, and ongoing system maintenance. through Intersourcing, an on-demand, hosted service model, it was a visionary form of outsourcing, and it has become For Ultimate Software and its investors, the advantages of the cornerstone of the company’s recurring revenue Intersourcing priced on a per-employee-per-month basis are growth plan. With the increasing popularity of Intersourcing, consistent recurring revenues and the enhanced opportunity Ultimate Software has transitioned successfully from to deliver predictable, dependable financial results. a letter to shareholders 2 2004 was a good year for Ultimate Software. The decision of UltiPro, and subscription revenues from fees generated to transform our business from a primarily license-based by business partners. model of UltiPro to a hybrid model that includes a higher percentage of recurring revenues was validated by our We increased total revenues by 19%, and we held our 2004 results. increase in operating expenses to 9%. We also generated $12 million in new annual recurring revenue (ARR) As forecasted, we achieved positive cash flow in both business in 2004. That’s squarely in line with our the third and fourth quarters of 2004, and we achieved targeted projection of $11 to $13 million, and the $12 profitability in the fourth quarter. The $39 million we million in ARR represents a 31% increase over the $9.2 produced in total recurring revenues in 2004 is a 33% million in ARR we produced in 2003. In the fourth increase over those in 2003, and above the 30% quarter of 2004, we generated a record $3.5 million objective we targeted in our business plan. Intersourcing in ARR. ARR is the key to our new business model’s revenues were the principal factor in our year-over-year strength, and our success in this area is an important growth in recurring revenues, which consist of maintenance contribution to the predictability of our financial revenues, Intersourcing revenues from our hosted offering performance moving forward. recurring revenues increased by 33% in 2004 $45 40 35 30 25 20 15 10 5 0 / $39.0 $29.3 54% $19.3 49% $14.4 24% 35% $10.5 17% 2000 2001 2002 2003 2004 In 2000, recurring revenues were $10.5 million, 17% of total revenues. In 2004, they were $39 million, 54% of total revenues. 3 We expanded our business service provider channel in 2004 1,000 client surveys we conducted this year, users ranked by signing agreements with three new distribution partners: our customer support team a 4.7 out of 5 for satisfaction. Aon Human Resources Outsourcing, a division of Aon None of this would have been possible without the Consulting, Inc.; Nationwide Mutual Insurance Company; unwavering support of the Ultimate Software family of and RSM McGladrey Employer Services, Inc., a part of RSM employees. I am humbled by their commitment and McGladrey Business Services, a wholly owned subsidiary of proud of their achievements. I am also grateful to our H&R Block. We have begun to work closely with all three shareholders and board of directors, who believe in our companies as they build their infrastructures and develop vision and understand the path we are taking to what I their sales and marketing plans. believe is a truly great future. Currently, our UltiPro Workforce Management solution Sincerely, benefits more than 1,200 customers that represent approximately 5,000 companies serving in excess of 2 million employees. This year, our customer retention rate Scott Scherr rose to an all-time high of 97%. In the approximately Chairman, President, and Chief Executive Officer Intersourcing, our on-demand, hosted service model, has gained in popularity over the last couple of years with new customers, as well as with our current customers that upgrade to Intersourcing, looking to reduce internal technology support requirements for their UltiPro Workforce Management solution. By the end of 2004, more than 225 companies representing 300,000 employees had selected Intersourcing. 4 UltiPro currently serves more than 1,200 customers that represent approximately 5,000 companies serving in excess of 2 million employees. Service Customer (UltiPro through Intersourcing) The Columbia House Company employees: 1,500 industry: retail headquarters: new york, ny The Columbia House Company, the nation’s largest direct marketer of home entertainment, needed an integrated system that manages payroll, human resources, and benefits processes with an intuitive user interface and comprehensive reporting. The company selected Ultimate Software’s Intersourcing because the solution offered the necessary functionality through UltiPro Workforce Management, along with the additional technology and ongoing support benefits of the on-demand hosted delivery model. The Columbia House Company is now “live,” finding UltiPro easy to use, and experiencing improved efficiencies, particularly with more flexible reporting. Intersourcing sales figured prominently in our 33% growth 1,100 employees in 2003 to approximately 1,300 in 2004. in recurring revenues in 2004 over 2003, and recurring In total, Ultimate Software generated $12 million in new revenues accounted for 54% of our total revenue in 2004, annual recurring revenues (ARR) in 2004. ARR represents the with total revenue at $72 million. The fourth quarter of 2004 expected one-year value from (i) new Intersourcing sales was the most successful quarter in Ultimate Software’s history (including prorated onetime charges); (ii) maintenance with total revenues of more than $20 million, a 24% increase revenues related to new license sales; (iii) recurring revenues over 2003’s final quarter. More than 60% of our new from new business service providers; and (iv) recurring customers in 2004 selected Intersourcing, and the average size revenues from additional sales to Ultimate Software’s of a new Intersourcing customer grew from approximately existing client base. 5 Service Customer (UltiPro through Intersourcing) License Customer (UltiPro on Customer’s Site) Sybra employees: 6,000 industry: hospitality headquarters: fort lauderdale, fl Quicken Loans employees: 2,250 industry: finance headquarters: livonia, mi Sybra, the second largest Arby’s franchisee in the United Prior to operating independently, Quicken Loans was owned States with 236 locations, upgraded from Ultimate and operated by Intuit, Inc., which used a large enterprise Software’s in-house version of UltiPro Workforce resource planning solution for human resources and a service Management to Intersourcing to gain more flexibility provider for payroll. When the companies separated, Quicken in managing the solution. Now Sybra, whose 6,000 Loans’ human resources team wanted a system with comparable employees are spread across 9 states, can run reports or functionality, and they needed it fast. The mortgage provider payroll from any location using a Web browser. Although selected UltiPro for its integrated human resources, benefits, most processing is done at company headquarters in Fort and payroll functionality, as well as its standard and customizable Lauderdale, Sybra’s staff liked the idea that they could reports and Web self-service. The company went “live” with be equally productive while in the office, on the road, the initial phase in 8 weeks and has advised us that it’s on or while working from home using only a laptop and track to save $100,000 annually after completing the second an Internet connection. phase of implementation. precisely what the customer needs delivered exactly how they want it For many executives, the final decision on whether to purchase a new HR/payroll solution comes down to total cost of ownership and return on investment. Ultimate Software solutions have met the criteria of the most discriminating and informed buyers. Customers that have purchased UltiPro as an on-site license and those that have acquired UltiPro as a service through Intersourcing and paid for it on a per-employee-per-month basis have had appealing results. Our customer case studies below illustrate the returns. 6 Service Customer (UltiPro through Intersourcing) License Customer (UltiPro on Customer’s Site) Genmar Holdings employees: 7,000 industry: manufacturing headquarters: minneapolis, mn Ruth’s Chris Steak House employees: 2,500 industry: hospitality headquarters: metairie, la Genmar Holdings, one of the largest global manufacturers When Ruth’s Chris Steak House decided to bring its of recreational boats, has reported saving $540,000 annually HR/payroll processes in-house in 2001, it was impressed since adopting Intersourcing, by eliminating service bureau with Ultimate Software’s comprehensive technology. fees and payments to an external HR/payroll auditor. A The restaurant chain has advised us that it has saved an company that has grown through acquisitions, Genmar average of $220,000 a year in service bureau fees, enjoys turned to UltiPro to consolidate its disparate solutions, improved reporting capabilities, and has greatly increased improve its reporting capabilities, and save money. In the productivity of its managers, HR/payroll department, addition, Genmar increased HR productivity, experienced and IT staff. Since implementing UltiPro, Ruth’s Chris has weekly time savings for the payroll department, and freed reported an annual ROI of 112%, with payback on the up its IT department. company’s initial investment in 11 months. UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ¥ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Ñscal year ended December 31, 2004 or n TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission Ñle number: 0-24347 The Ultimate Software Group, Inc. (Exact name of Registrant as speciÑed in its charter) Delaware (State or other jurisdiction of incorporation or organization) 2000 Ultimate Way, Weston, FL (Address of principal executive oÇces) 65-0694077 (I.R.S. Employer IdentiÑcation No.) 33326 (Zip Code) Registrant's telephone number, including area code: (954) 331-7000 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Title of Class: Common Stock, par value $.01 per share Indicate by check mark whether the Registrant (1) has Ñled all reports required to be Ñled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to Ñle such reports), and (2) has been subject to such Ñling requirements for the past 90 days. Yes ¥ No n Indicate by check mark if disclosure of delinquent Ñlers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in deÑnitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. n Indicate by check mark whether the Registrant is an accelerated Ñler (as deÑned in Exchange Act Rule 12b-2). Yes ¥ No n The aggregate market value of Common Stock, par value $.01 per share, held by non-aÇliates of the Registrant, based upon the closing sale price of such shares on the Nasdaq National Market on June 30, 2004 was approximately $185.8 million. As of February 18, 2005, there were 22,558,866 shares of the Registrant's Common Stock, par value $.01, outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant's Proxy Statement for the 2005 Annual Meeting of Stockholders are incorporated by reference into Part III of this Annual Report on Form 10-K. THE ULTIMATE SOFTWARE GROUP, INC. INDEX Item 1. Item 2. Item 3. Item 4. Item 5. Item 6. Item 7. Item 7A. Item 8. Item 9. Item 9A. Item 9B. Item 10. Item 11. Item 12. Item 13. Item 14. PART I BusinessÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Properties ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Legal Proceedings ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Submission of Matters to a Vote of Security HoldersÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ PART II Market for the Registrant's Common Equity and Related Stockholder Matters ÏÏÏÏ Selected Financial Data ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Management's Discussion and Analysis of Financial Condition and Results of OperationsÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Quantitative and Qualitative Disclosures about Market Risk ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Financial Statements and Supplementary Data ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Changes in and Disagreements With Accountants on Accounting and Financial Disclosure ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Controls and Procedures ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Other Information ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ PART III Directors and Executive OÇcers of the Registrant ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Executive Compensation ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Security Ownership of Certain BeneÑcial Owners and Management and Related Stockholder Matters ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Certain Relationships and Related Transactions ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Principal Accountant Fees and Services ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ PART IV Exhibits and Financial Statement Schedules ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Item 15. Signatures ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Page(s) 1 12 12 12 13 14 15 33 33 56 56 58 59 62 62 62 62 62 68 PART I This Annual Report on Form 10-K (the ""Form 10-K'') of The Ultimate Software Group, Inc. (""Ultimate Software'' or the ""Company'') may contain certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements represent the Company's expectations or beliefs, including, but not limited to, statements concerning the Company's operations and Ñnancial performance and condition. Words such as ""anticipates,'' ""expects,'' ""intends,'' ""plans,'' ""believes,'' ""seeks,'' ""estimates,'' and similar expressions are intended to identify such forward-looking statements. These forward- looking statements are not guarantees of future performance and are subject to certain risks and uncertainties that are diÇcult to predict. The Company's actual results could diÅer materially from those contained in the forward-looking statements due to risks and uncertainties associated with Öuctuations in the Company's quarterly operating results, concentration of the Company's product oÅerings, development risks involved with new products and technologies, competition, the Company's contractual relationships with third parties, contract renewals with business partners, compliance by our customers with the terms of their contracts with us, and other factors disclosed in the Company's Ñlings with the Securities and Exchange Commission. Other factors that may cause such diÅerences include, but are not limited to, those discussed in this Form 10-K, including Exhibit 99.1 hereto. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. UltiPro» and Intersourcing» and their related designs are registered trademarks of Ultimate Software in the United States. This Form 10-K also includes names, trademarks, service marks and registered trademarks and service marks of companies other than Ultimate Software. Item 1. Business Overview Ultimate Software designs, markets, implements and supports payroll and workforce management solutions in the United States. Ultimate Software's UltiPro Workforce Management Software (""UltiPro'') is a Web-based solution designed to deliver the functionality businesses need to manage the employee life cycle, from recruiting and hiring to compensating and managing beneÑts to terminating, whether their processes are centralized at headquarters or distributed across multiple divisions or branch oÇces. UltiPro's human resources (""HR'') and beneÑts management functionality is wholly integrated with a Öexible payroll engine, reporting and analytical decision-making tools, and a self-service Web portal for executives, managers, administrators, and employees to review and update work-related and personal information. Ultimate Software believes that UltiPro helps customers streamline HR and payroll processes to signiÑcantly reduce administrative and operational costs, while also empowering managers and staÅ to analyze workforce trends for better decision making, access critical information quickly and perform routine business activities eÇciently. UltiPro Workforce Management is marketed both through the Company's direct sales team as well as through alliances with business service providers (""BSPs'') that market co-branded UltiPro to their customer bases. Ultimate Software's direct sales team focuses primarily on companies with more than 500 employees and sells UltiPro both as a license model (typically in-house) and a service model (typically hosted and priced on a per-employee-per-month basis). The Company's BSP alliances focus primarily on companies with under 500 employees and typically sell an Internet solution, which includes UltiPro, priced on a monthly/service basis. In 2004, Ultimate Software extended its BSP program to allow for alliances that target very large corporations, generally those having more than 10,000 employees that the Company's direct sales force would not see in a typical sales process. When the BSP sells its Internet solution, incorporating UltiPro in the oÅering, the BSP is obligated to remit a fee to the Company, typically measured on a per-employee-per- month basis and, in some cases, subject to a guaranteed monthly minimum amount. UltiPro leverages the Microsoft technology platform, which is recognized in the industry as a cost- eÅective, reliable and scalable platform. As part of its comprehensive payroll and workforce management solutions, Ultimate Software provides implementation and training services to its customers as well as support services, which have been certiÑed by the Support Center Practices CertiÑcation program for six consecutive annual evaluations. The Company's direct sales force markets UltiPro as an in-house human resources, payroll and workforce management solution and alternatively as a hosted oÅering branded ""Intersourcing'' (the ""Intersourcing OÅering''). Intersourcing provides Web access to comprehensive workforce management functionality for organizations that need to simplify the information technology (IT) support requirements of their business applications. Ultimate Software believes that Intersourcing is attractive to companies that want to focus on their core competencies to increase sales and proÑts. Through the Intersourcing model introduced in 2002, the Company provides the hardware, infrastructure, ongoing maintenance and backup services for its customers at a BellSouth data center managed by International Business Machines (""IBM''). During 2001, Ultimate Software and Ceridian Corporation (""Ceridian'') reached an agreement, as amended in 2002, which granted Ceridian a non-exclusive license to use UltiPro software as part of an on-line oÅering that Ceridian markets primarily to businesses with less than 500 employees (the ""Original Ceridian Agreement''). Ceridian marketed this oÅering as the SourceWeb solution, which uses UltiPro software as its core payroll and human resource platform. According to the Ñnancial terms of the Original Ceridian Agreement (the ""Ceridian Financial Terms''), Ceridian is required (i) to pay the Company a monthly license fee based on the number of employees paid using the licensed software, subject to a minimum monthly payment of $500,000 per month with increases of 5% per annum, compounded beginning in January 2006. The aggregate minimum payments that Ceridian is obligated to pay Ultimate Software under the Original Ceridian Agreement over the minimum term of the agreement are $42.7 million. To date, Ceridian has paid to Ultimate Software a total of $23.0 million under the Original Ceridian Agreement. The earliest date upon which the Ceridian Agreement can be terminated by either party (except for an uncured material breach) is March 9, 2008, resulting in an expected minimum term of 7 years. Ceridian retains certain rights to use the software upon termination. During December 2004, RSM McGladrey Employer Services (""RSM''), an existing business service provider of Ultimate Software's, acquired Ceridian's SourceWeb HR/payroll and self-service product and existing SourceWeb base of small and midsize business customers throughout the United States (the ""RSM Acquisition''). The Ceridian Financial Terms have not changed as a result of the RSM Acquisition. Ultimate Software expects to continue to recognize a minimum of $642,000 per month in recurring revenues from the Original Ceridian Agreement until its termination. Ultimate Software is a Delaware corporation formed in April 1996 to assume the business and operations of The Ultimate Software Group, Ltd. (the ""Partnership''), a limited partnership founded in 1990. Ultimate Software's headquarters is located at 2000 Ultimate Way, Weston, Florida 33326 and its telephone number is (954) 331-7000. To date, the Company has derived no revenue from customers outside of the United States and has no assets located outside of the United States. Revenue Sources The Company's revenues are derived from three principal sources: recurring revenues, services revenues and software licenses (""license revenues''). Recurring revenues consist of maintenance revenues, Intersourcing revenues and subscription revenues from per-employee-per-month (""PEPM'') fees generated by business partners. Maintenance revenues are derived from maintaining, supporting and providing periodic updates for the Company's products under software license agreements. Subscription revenues are principally derived from PEPM fees earned through the Intersourcing OÅering, Base Hosting (deÑned below) and the BSP sales channel, as well as revenues generated from the Original Ceridian Agreement. Maintenance revenues are recognized ratably over the service period, generally one year. To the extent there are upfront fees associated with the Intersourcing OÅering, Base Hosting or the BSP sales channel, subscription revenues are recognized ratably over the term of the related contract upon the delivery of the product and services. PEPM fees from the Intersourcing OÅering, 2 Base Hosting and the BSP sales channel are recognized as subscription revenue (a component of recurring revenues in the consolidated statements of operations) as the services are delivered. Services revenues include revenues from fees charged for the implementation of the Company's software products and training of customers in the use of such products, fees for services provided to business service providers, including those related to the Ceridian Services Agreement (deÑned below) which expired on December 31, 2004, the provision of payroll-related forms and the printing of Form W-2's for certain customers and certain reimbursable out-of-pocket expenses. Revenues for training and implementation consulting services are typically recognized as services are performed. Revenues for the Ceridian Services Agreement were recognized ratably from February 11, 2003 until December 31, 2004 based on the terms of the agreement. Other services are recognized as the services are rendered or as the product is shipped. License revenues include revenues from software license agreements for the Company's products, entered into between the Company and its customers in which the license fees are non-cancellable. License revenues are generally recognized upon the delivery of the related software product when all signiÑcant contractual obligations have been satisÑed. Until such delivery, the Company records amounts received when contracts are signed as customer deposits which are included with deferred revenues in the consolidated balance sheets. The percentage contribution for each of the three principal sources of revenue was as follows: For the Years Ended December 31, 2002 2003 2004 Revenues: Recurring ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Services ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ License ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 54.2% 34.6 11.2 48.6% 38.8 12.6 35.1% 42.8 22.1 Total revenues ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 100.0% 100.0% 100.0% Features of UltiPro Ultimate Software's UltiPro is a payroll and workforce management solution designed to oÅer the following features to its customers: Web Workforce Portal. UltiPro includes a Web workforce portal that can serve as a company's communications hub and the central gateway for business activities. It provides functionality for everyone in the customer's organization, not just human resources/payroll and Ñnance departments, but also executives, staÅ managers and individual employees. With UltiPro's workforce portal, a company's HR/payroll staÅ, managers and administrators can complete daily employee administration tasks, administer beneÑts, manage staÅ and access reporting in real-time, from one central location. Managers and executives can perform real- time Web queries on their workforce data, access commonly requested reports and analyze workforce statistics and trends on-demand. Employees can review their own pay and beneÑts information, get questions answered and complete routine updates instantly. HR and other administrators can expedite more than 100 routine business processes such as hiring, rehiring or terminating an employee; inputting salary increases; and changing an employee's job, division, or department. Ultimate Software believes that UltiPro's workforce portal can increase administrative eÇciencies by providing reporting, staÅ management processes and business intelligence to management over the Internet and can reduce operating costs by eliminating the need for organizations to print and distribute paper communications, handbooks, forms and paychecks. Feature-Rich, Built-in Functionality. UltiPro includes human resources, payroll, and beneÑts manage- ment, comprehensive reporting (more than 400 standard and customizable reports delivered, including government compliance reporting and strategic analytics), a workforce portal with Web-based employee and manager self-service, Web-based beneÑts enrollment, Web employee administration (including workÖow), recruitment and training management. Based upon the amount of built-in and integrated functionality, the Company believes that UltiPro minimizes the need for extensive customizations or changes to source code, 3 facilitates streamlined management of the total employment cycle, and enables organizations to minimize the time invested in burdensome HR/payroll administrative activities. Implementation and System Update EÇciency. Ultimate Software oÅers a solution that has been designed to minimize the time and eÅort required for implementation, customization and updating. UltiPro delivers an extensive amount of functionality ""out-of-the-box'' so that minimal customizations are required by the customer. The Company also provides an implementation methodology, experienced implementation staÅ and customer training to facilitate rapid implementation. Ultimate Software continues to reÑne and improve its implementation process to allow customers to implement more quickly. To facilitate customizations and fast system upgrades, the Company has designed UltiPro so that when users load system updates, they do not overwrite their customizations because the system stores custom changes as sub-classed objects or data that reside ""outside'' the core program, thus avoiding the time-consuming process of rewriting custom changes. Reduced Total Cost of Ownership. The Company believes that the UltiPro solution provides cost saving opportunities for its customers and that UltiPro, whether purchased as a license or as a service through Intersourcing, is competitively priced. In addition, the Company believes that its current practices in implementing the UltiPro solution result in a cost savings for customers when compared with implementations of other similar solutions in the industry. A customer may also reduce the administrative and information technology support costs associated with the organization's human resources, beneÑts and payroll functions over time. Tight integration helps to reduce administrative costs by facilitating accurate information processing and reporting, and reducing discrepancies, errors and the need for time-consuming adjustments. In addition, administrative costs can be reduced by providing an organization with greater access to information and control over reporting. Leveraging of Leading Technologies. Ultimate Software has consistently focused on identifying leading technologies and integrating them into its products. UltiPro Workforce Management is a three-tier solution that leverages Microsoft's technical architecture as well as XML to increase design eÇciencies within the system and particularly for workÖow capabilities. With UltiPro version 6.0, released in 2002, Ultimate Software introduced new technology architecture for UltiPro to enable advanced Web Services capabilities. Ultimate Software's Distributed Process Management platform leverages leading technologies such as Microsoft's Component Object Model (COM), Microsoft Message Queuing (MSMQ), eXtensible Markup Language (XML), Simple Object Access Protocol (SOAP) and Web Services DeÑnition Language (WSDL) to create a distributed processing framework that is Internet-enabled. This allows customers to initiate commonly requested services such as running a report from the Web. These requests are automatically routed to a separate process application server to ensure eÇcient processing and load balancing. UltiPro's XML Web Services feature set allows customers to scale as they grow and take advantage of additional Web Services as needed. With UltiPro version 7.0, released in 2003, Ultimate Software enhanced and validated the performance of UltiPro's Internet functions, including eEmployee Self-Service, eManagement, and eAdminis- tration by benchmark testing with Mercury Loadrunner Controller. In addition, UltiPro includes a suite of enterprise integration tools, business components and business-to-business links. These tools are designed to take advantage of emerging Internet-based technology standards such as XML, HTTP and Java scripting. Ease of Use and Navigation. Ultimate Software designs its products to be user-friendly and to simplify the complexities of managing employees and complying with government regulations in the payroll and workforce management areas. UltiPro uses familiar Internet interface techniques and functions through a Web browser, which the Company believes makes it convenient and easy to use. A customer's executives, managers, administrators and employees have Web access to manage payroll and employee functions, run reports or Ñnd answers to routine questions through an intuitive user interface. The Company refers to this easy navigation as ""Two clicks to anywhere.'' Comprehensive Professional Services and Industry-SpeciÑc Expertise. Ultimate Software believes it provides high quality implementation, training and ongoing product and customer support services. Ultimate Software employs approximately 170 people in customer services, which includes the implementation, product support, technical support and training departments. Ultimate Software's customer support center has received the Support Center Practices (""SCP'') CertiÑcation for the sixth consecutive year. The SCP 4 program was created by the Service & Support Professionals Association (SSPA) and a consortium of information technology companies to create a recognized quality certiÑcation for support centers. SCP CertiÑcation quantiÑes the eÅectiveness of customer support based upon relevant performance standards and represents best practices within the technology support industry according to SSPA. Recognizing the importance of issuing timely updates that reÖect changes in tax and other regulatory laws, Ultimate Software employs a dedicated research team to track jurisdictional tax changes to the more than 12,000 tax codes included in UltiPro as well as changes in other employee-related regulations. Technology Ultimate Software seeks to provide its clients with optimum performance, advanced functionality and ease of scalability and access to information through the use of leading Internet standard technologies. The UltiPro Workforce Management solution was designed to leverage cutting-edge technologies such as XML and Web Services that use open standards to provide customers with a cost-eÅective platform for performing critical business functions rapidly over the Web and allowing diÅerent systems to communicate with one another. The use of Microsoft technology helps the Company to deliver what it believes to be a highly deployable and manageable payroll and workforce management solution that includes the following key technological features: Web-Based Technologies and Internet Integration. Ultimate Software supports emerging Web technol- ogies and Internet/extranet connectivity to increase access to and usability of its applications. UltiPro is a Web solution with a back oÇce component for handling such functions as payroll processing, company and system setup, and security. One of the highlights of UltiPro's technology is the Company's Distributed Process Management (""DPM'') framework of XML Web Services, a framework that enables business functions to be performed over the Web, and allows diÅerent enterprise systems to talk to one another over the Internet. UltiPro's DPM was designed to automate and distribute HR and payroll processes, for example, entering group time or generating reports, across multiple servers to reduce the amount of time and manual work required. The DPM framework leverages Microsoft's Component Object Model (COM), eXtensible Markup Language (XML), Simple Object Access Protocol (SOAP), Web Services DeÑnition Language (WSDL) and Microsoft Message Queuing (MSMQ) to improve system speed and performance. The Company believes that the DPM framework makes UltiPro highly scalable to accommodate a high volume of processing requests cost-eÅectively, particularly for companies that run hundreds or even thousands of payrolls. Application Framework. Ultimate Software has designed certain aspects of its system using a multi- tiered architecture in order to enhance the system's speed, Öexibility, scalability and maintainability. When an application's logic resides only on a client workstation, a user's ability to process high volume data transactions is limited. When the logic resides only on a server, the user's interactive capabilities are reduced. To overcome such limitations, Ultimate Software built more separation into the application design to increase the extensibility, scalability and maintainability of the application. The UltiPro Workforce Management applica- tion consists of several core components in a layered architecture that leverages Microsoft technology. UltiPro's multi-layered architecture, including an Operating System Layer, Business Logic Layer, Presenta- tion Layer and User Interface Layer, makes it easier to update and maintain UltiPro, as well as integrate UltiPro with other enterprise systems. The Company believes that UltiPro's application framework provides a highly extensible set of services that can scale depending on the customer's business size. In addition, UltiPro was built using a data-driven, object-oriented application framework that enhances the development and usability of the solution. Object-oriented programming features code reusability and visual form/object inheritance, which decrease the time and cost of developing and fully implementing a new system. With object-oriented programming, system updates do not overwrite prior customizations to the system because custom changes are sub-classed objects that reside ""outside'' the core program. Business Intelligence Tools. In addition to an extensive library of standard reports that oÅer Öexibility and ease of use, the Company extends what users can do with employee data by embedding business intelligence tools from Cognos Corporation, a third-party provider (""Cognos''). In addition to oÅering sophisticated data query and report authoring, these tools enable users to apply online analytical processing 5 (""OLAP'') to multidimensional data cubes, allowing users to explore data on employees graphically and statistically from diverse angles. Ultimate Software maintains a link between Cognos' report catalog and UltiPro's data dictionary, eliminating the necessity for users to create and maintain ad hoc reporting catalogs. A Cognos Web Package is delivered to UltiPro customers to allow users to access reports and conduct data queries from a Web browser. Ultimate Software Solutions Ultimate Software's core solution, UltiPro Workforce Management, was originally designed for mid- sized enterprise customers, primarily those with 500 to 15,000 employees but is appropriate for and is used by both smaller and larger organizations. Ultimate Software also oÅers the ""Powered by UltiPro'' BSP Solution (the ""BSP Solution'') with Internet Payroll to business services providers that have relationships with smaller organizations, typically those with fewer than 500 employees and, since 2004, is now available to BSPs to use for very large corporations. UltiPro Workforce Management Software (""UltiPro'') UltiPro Workforce Management is designed to provide customers the functionality they need to manage every aspect of the employee life cycle in one place, from recruiting and hiring to compensating and managing beneÑts to terminating, whether a customer's processes are centralized at headquarters or managed by multiple divisions or branch oÇces. UltiPro's HR and beneÑts management functionality is wholly integrated with a Öexible payroll engine, reporting and analytical decision-making tools, and a central Web portal that can serve as the customer's gateway for its workforce to access company-related activities. Ultimate Software believes that UltiPro helps customers streamline HR and payroll processes to signiÑcantly reduce administra- tion and operational costs, while also empowering executives and staÅ to access critical information quickly and perform routine business activities more eÇciently. UltiPro Workforce includes, but is not limited to, the following functionality: UltiPro's Workforce Portal. UltiPro's workforce portal can act as the gateway for a company's executives, management team, HR/payroll staÅ, administrators, and employees to business activities. Ultimate Software believes that UltiPro's workforce portal allows its customers to improve service to their employees through better communications and save time because managers and administrators can complete hundreds of common employee-related tasks, including administering beneÑts, managing staÅ and accessing reporting and business intelligence in real-time, from one central location. eManager Self-Service. As authorized, managers have self-service access to staÅ information such as salary, compensation history, key dates and emergency contacts, with reporting and workforce analysis tools to facilitate decision-making. A customer's managers can view and update staÅ information, manage department activities, post job openings, leverage recruiting and hiring tools, and perform Web queries on workforce data. UltiPro's document management features can be used to house and categorize employee-related documents such as drivers' licenses, consent forms, and completed I-9s with required identiÑcation. Administrators and managers have the ability to attach Microsoft Word documents, PDFs, JPEG Ñles, spreadsheets, or any other Ñle types supported by Microsoft Internet Explorer to employee Ñles. The documents can be grouped and sorted to individual requirements, as necessary. eEmployee Self-Service. UltiPro eEmployee Self-Service gives a customer's employees immediate security-protected access to view their own paycheck details and beneÑts summaries, frequently used forms and company information. They can also update personal information such as address, phone number, emergency contacts and skills; change preferences such as direct deposit accounts and beneÑts selections; make routine requests such as asking for vacation time; and enroll in training. eAdministration. UltiPro's eAdministration includes eWork Events, eStandard Reporting, and eSystem Administration. eWork Events enables users to authorize HR/payroll staÅ, managers or supervisors to make updates on the Web through more than 100 pre-deÑned workÖow processes to expedite business activities such as hiring an employee or inputting a salary increase. eStandard Reporting allows authorized managers or 6 HR/payroll staÅ to run standard UltiPro reports, including upcoming performance reviews, headcount reports, average salary reports, government compliance reports, general ledger reporting, and other point-in-time HR/payroll reports from the Web without requiring the time of central HR/payroll or IT staÅ. eSystem Administration was designed for the non-technical user to administer UltiPro's roles-based security, built-in workÖow and system business rules, as well as enable system administrators to post company communications, link to external Web sites from the UltiPro portal, and, through UltiPro's ePalette feature, select the colors of UltiPro's Web pages to match the customer's own company image. eHuman Resources. UltiPro tracks HR-related information including employment history, perform- ance, job and salary information, career development, and health and wellness programs. In addition, UltiPro facilitates the recording and tracking of key information for government compliance and reporting, including Consolidated Omnibus Budget Reconciliation Act compliance; Health Insurance Portability & Accountability Act certiÑcates; Occupational Safety & Health Administration and workers' compensation; Family Medical Leave Act tracking; and Equal Employment Opportunity compliance. UltiPro also ensures compliance with the Health Insurance Portability & Accountability Act conÑdentiality legislation for protecting sensitive data such as employee social security numbers. eHuman Resources includes beneÑts administration, recruitment and staÇng tools, compensation management and training management functionality. Payroll Processing. UltiPro's payroll engine handles hundreds of payroll-related computations intended to minimize the customer's need for side calculations or additional programming. For example, UltiPro delivers complex wage calculations such as average pay rates for overtime calculations, shift premiums, garnishments and levy calculations. With ePayroll Processing, a company's central payroll department, remote oÇces or multiple divisions can process payroll on the Web in several steps. ePayroll Processing includes eTime Entry to allow customers' supervisors or managers at branch oÇces to input and submit time for their team through the Web. UltiPro Business Intelligence. Using UltiPro's Business Intelligence tools, customers can provide their managers and executives with Web access to workforce-related reports, workforce analytics and point-in-time reporting, without installing reporting software on users' PCs or writing custom reports. With UltiPro Business Intelligence, users can run and print pre-formatted reports for the executive team or run instant queries on the Web for answers to routine questions. UltiPro Business Intelligence also delivers workforce analytics to enable managers to evaluate workforce trends strategically on topics such as compensation, turnover and overtime. eTraining Enrollment. With eTraining Enrollment, customers' employees can view course schedules and descriptions and register online. Managers can also approve staÅ training requests from the Web. eBeneÑts Enrollment. With eBeneÑts Enrollment, customers' employees can review their beneÑt choices and make selections on the Web. BeneÑts administrators can set up enrollment sessions from the Web and use tools to monitor enrollment progress. eBeneÑts Enrollment also walks employees through all of the beneÑt and personal information changes necessary as a result of a life event such as getting married, having a baby or moving. eRecruitment. UltiPro eRecruitment automates, tracks and manages the hiring and recruiting process to help reduce overall ""cost per hire'' and ""time to hire.'' With UltiPro eRecruitment, users can post openings to job sites they subscribe to, track applications and hire candidates from within UltiPro's workforce portal. eCo-Branding. For organizations that want to co-brand UltiPro for the purpose of delivering services to a customer base, UltiPro oÅers eCo-Branding as an extra-cost option. eCo-Branding provides Web access to important personal information for customers' employees, including the ability to view current paycheck and direct deposit details, paycheck history and beneÑts details. Customers can display their own company logo with the ""Powered by UltiPro'' logo to their user base to strengthen their brand. Position Management. UltiPro Position Management helps customers manage their resource budget, measure trends and forecast future needs. Users can manage by full-time employee equivalents and dollars, and evaluate budgeted versus actual numbers. Authorized users can check the status of fund allocations, available open positions and staÇng requirements. Because HR and payroll are integrated, reporting on position information for budgeted and actual does not require multiple spreadsheets. 7 UltiPro Wireless. Ultimate Software recognizes the mobile workforce today and delivers a wireless application geared for today's mobile employees, managers, administrators and executives. UltiPro Wireless provides employees with access to their paycheck details and company directory via a wireless device. Managers can elect to receive wireless notiÑcations for workÖow events requiring their approval (such as an employee vacation request). Other Key Features. UltiPro also includes Tax Management to deliver Federal, state and local tax updates automatically every quarter as part of the core solution; Enterprise Integration Tools that provide the ability to interface with third-party applications and providers such as general ledger, tax Ñling services, time clocks, banks, 401(k) and beneÑt providers, check printing services and unemployment management services; and Distributed Process Management XML Web Services that batch and distribute HRMS/payroll processes across multiple servers to increase eÇciency, reduce the time required to ensure processes are completed, and allow them to be initiated over the Web. ""Powered by UltiPro'' BSP Solution (the ""BSP Solution'') ""Powered by UltiPro'' BSP Solution is designed for and primarily marketed to business service providers that have relationships with smaller organizations, those with fewer than 500 employees. The BSP Solution enables business service providers to deliver Web-based workforce management and payroll services to their customers and Web-access for their customers' employees to view their paycheck and basic beneÑts information. In 2004, Ultimate Software extended its BSP program to allow BSPs that target very large corporations to use UltiPro as part of an HR Outsourcing oÅering. The very large corporations targeted in this type of oÅering, generally having more than 10,000 employees would be those that Ultimate Software's direct sales force would not typically see in the sales process. Business service providers have the opportunity to co- brand UltiPro and to price their oÅerings on a per-employee-per-month or other monthly basis. The BSP Solution has been packaged to be easy to use and convenient for smaller companies and is appropriate for larger companies as well. For the small company market, companies with less than 500 employees, the BSP Solution leverages select functionality from UltiPro Workforce Management, and have a specially designed Web browser interface for payroll administrators to sign up their businesses for the service, enter employee hours worked and submit payroll. If there are no changes to employees' standard paycheck information, submitting a payroll generally can be done in less than a minute by clicking an icon. With changes, the process generally can take several minutes. The initial process of registering for Web payroll services generally takes less than an hour if the administrator has all the appropriate data available for entry. To ensure the process is rapid and easy for registrants, there is a checklist online with what they need before beginning the signup process. Through a secure, password-protected login, employees can view their current paycheck and direct deposit details, paycheck history, and beneÑts details such as medical, dental and 401(k) deductions. Intersourcing OÅering In 2002, the Company began oÅering a hosting service, branded Intersourcing, whereby the Company provides the hardware, infrastructure, ongoing maintenance and back-up services for its customers at a BellSouth data center managed by IBM (the ""Intersourcing OÅering''). DiÅerent types of hosting arrange- ments include the sale of hosting services as a part of the Intersourcing OÅering, discussed below, and, to a lesser extent, the sale of hosting services to customers that license UltiPro on a perpetual basis (""Base Hosting''). Hosting services, typically available in a shared environment, provide Web access to comprehen- sive workforce management functionality for organizations that need to simplify the information technology (IT) support requirements of their business applications and are priced on a per-employee-per-month basis. In the shared environment, Ultimate Software provides an infrastructure with applicable servers shared among many customers who use a Web browser to access the application software through the data center. The Intersourcing OÅering is designed to provide an appealing pricing structure to customers who prefer to minimize the initial cash outlay associated with typical capital expenditures. Intersourcing customers purchase the right to use UltiPro on an ongoing basis for a speciÑc term in a shared or dedicated hosted 8 environment. The pricing for Intersourcing, including both the hosting element as well as the right to use UltiPro, is on a per-employee-per-month basis. Research and Development Activities Ultimate Software incurs research and development expenses, consisting primarily of software develop- ment personnel costs, in the normal course of its business. Such research and development expenses are for enhancements and future betterments to the Company's existing products and for the development of new products. During 2004, 2003 and 2002, the Company spent $18.3 million, $18.2 million and $17.7 million, respectively, on research and development activities, which corresponds with the related amounts expensed in the consolidated statements of operations during those periods. There were no software costs capitalized in 2004, 2003 or 2002. Customer Services Ultimate Software believes that delivering quality customer services provides the Company with a signiÑcant opportunity to diÅerentiate itself in the marketplace and is critical to the comprehensive solution. Ultimate Software provides its customers services in two broad categories: (i) professional services which includes implementation, customer relationship management, and educational services and (ii) customer support services and maintenance. Professional Services. Ultimate Software's professional services include implementation, customer relationship management and educational services. Ultimate Software believes that its implementation services are diÅerentiated from those of other vendors by speed, predictability and completeness. The Company believes that its successful record with rapid implementations is due to its standardized methodol- ogy, long-tenured consultants, the large amount of delivered product functionality, and comprehensive conversion and integration tools. Ultimate Software has an experienced team of system and functional consultants that are dedicated to assisting customers with rapid implementations. In addition, Ultimate Software provides its customers with the opportunity to participate in formal training programs conducted by its education services team. Training programs are designed to increase customers' ability to use the full functionality of the product, thereby maximizing the value of customers' investments. Courses are designed to align with the stages of implementa- tion and to give attendees hands-on experience with UltiPro. Trainees learn such basics as how to enter new employee information, set up beneÑt plans and generate standard reports, as well as more complex processes such as deÑning company rules, customizing the system and creating custom reports. The Company maintains training facilities in Atlanta, Georgia; Schaumburg, Illinois; Dallas, Texas; and at its headquarters in Weston, Florida. In addition to oÅering classes at these facilities, the Company conducts Web-based training and on- site training at customer facilities. After customers have implemented UltiPro and have been turned over to the Company's customer support and maintenance program, the Company assigns a customer relationship manager to the account to assist customers on an ongoing basis with special projects, including enhancing their existing systems, managing upgrades and writing custom reports. These services, like all of the Company's professional services, are typically billed on a time and materials basis. Customer Support and Maintenance. Ultimate Software oÅers comprehensive technical support and maintenance services, which have historically been purchased by all of its customers. Ultimate Software's customer support center has received the Support Center Practices CertiÑcation sponsored by the Service Strategies Corporation (SSC) for the sixth consecutive year. This certiÑcation recognizes companies that ""deliver exceptional service and support to their customers.'' Ultimate Software's customer support services include: software updates that reÖect tax and other legislative changes; telephone support 24 hours a day, 7 days a week; unlimited access to the Company's employee tax center on the World Wide Web; seminars on year-end closing procedures; and periodic newswires. In addition, the Company's customer support services team maintains a support Web site for its customers and individual representatives attend user-organized user group meetings on a routine basis throughout the United States. 9 Customers As of December 31, 2004, Ultimate Software had licensed its software to more than 1,200 customers that represent approximately 5,000 companies serving in excess of 2 million employees. Ultimate Software's customers operate in a wide variety of industries, including manufacturing, food services, sports, technology, Ñnance, insurance, retail, real estate, transportation, communications, healthcare and services. During 2004 and 2003, one of the Company's customers, Ceridian, accounted for 16% and 17%, respectively, of total revenues. Ceridian did not account for more than 10% of total revenues in 2002. No other customer accounted for more than 10% of total revenues in 2004, 2003 or 2002. Sales and Marketing Ultimate Software markets and sells its products and services through its direct sales force, marketing group, and a network of business service provider alliances. Direct Sales. Ultimate Software's direct sales force includes business development vice presidents, directors and managers who have deÑned territories. The sales cycle begins with a sales lead generated through a national, corporate marketing campaign or a territory-based activity. In one or more on-site visits, sales managers work with application and technical consultants to analyze prospective client needs, demon- strate the Company's product and, when required, respond to RFPs (Requests for Proposals). The sale is Ñnalized after clients complete their internal sign-oÅ procedures and terms of the contract are negotiated and signed. With a license sale, the terms of the Company's sales contract typically include a license agreement for the product, an annual maintenance agreement, per-day training rates and hourly charges for implementation services. Typical payment terms include a deposit at the time the contract is signed and additional payments upon the occurrence of other speciÑed events such as the implementation of the software and/or speciÑc payment dates designated in the contract. Payment for implementation and training services under the contract is typically made as such services are provided. A service sale is a hosting, or Intersourcing, agreement that typically requires, but is not limited to, a per-employee-per-month fee, setup fees and hourly charges for implementation. Business Service Provider (BSP) Network. The BSP network is a co-branding alliance strategy that enables BSPs to co-brand and market UltiPro and/or the BSP Solution primarily to businesses with fewer than 500 employees and, since 2004, is available for very large companies, generally those having more than 10,000 employees, as well. The goal of the program is to extend the Company's market penetration in markets where the Company's direct sales force does not have a signiÑcant presence and to build a recurring revenue stream through per-employee-per-month pricing. Marketing. Ultimate Software supports its sales force with a comprehensive marketing program that includes public relations, advertising, direct mail, trade shows, seminars and Web site maintenance. Working closely with the direct sales force, customers and strategic partners, the marketing team deÑnes positioning strategies and develops a well-deÑned plan for implementing these strategies. Marketing services include market surveys and research, overall campaign management, creative development, production control, demand generation, results analysis, and communications with Ñeld oÇces, customers and marketing partners. Intellectual Property Rights The Company's success is dependent in part on its ability to protect its proprietary technology. The Company relies on a combination of copyright, trademark and trade secret laws, as well as conÑdentiality agreements and licensing arrangements, to establish and protect its proprietary rights. The Company does not have any patents or patent applications pending, and existing copyright, trademark and trade secret laws aÅord only limited protection. Accordingly, there can be no assurance that the Company will be able to protect its proprietary rights against unauthorized third-party copying or use, which could materially adversely aÅect the Company's business, operating results and Ñnancial condition. 10 Despite the Company's eÅorts to protect its proprietary rights, attempts may be made to copy or reverse engineer aspects of the Company's products or to obtain and use information that the Company regards as proprietary. Moreover, there can be no assurance that others will not develop products that perform comparably to the Company's proprietary products. Policing the unauthorized use of the Company's products is diÇcult. Litigation may be necessary in the future to enforce the Company's intellectual property rights, to protect the Company's trademarks, copyrights or trade secrets or to determine the validity and scope of the proprietary rights of others. Such litigation could result in substantial costs and diversion of resources and could have a material adverse eÅect on the Company's business, operating results and Ñnancial condition. As is common in the software industry, the Company from time to time may become aware of third-party claims of infringement by the Company's products of third-party proprietary rights. While the Company is not currently subject to any such claim, the Company's software products may increasingly be subject to such claims as the number of products and competitors in the Company's industry segments grows and the functionality of products overlaps and as the issuance of software patents becomes increasingly common. Any such claim, with or without merit, could result in signiÑcant litigation costs and require the Company to enter into royalty and licensing agreements, which could have a material adverse eÅect on the Company's business, operating results and Ñnancial condition. Such royalty and licensing agreements, if required, may not be available on terms acceptable by the Company or at all. Competition The market for the Company's products is highly competitive. The Company's products compete primarily on the basis of technology, delivered functionality and price/performance. Ultimate Software's competitors include (i) large service bureaus, primarily ADP and, to a lesser extent, Ceridian; (ii) companies, such as PeopleSoft/Oracle and Kronos, that oÅer human resource management and payroll (""HRMS/payroll'') software products for use on mainframes, client/server environments and/or Web servers; and (iii) the internal payroll/human resources departments of potential customers which use custom- written software. Many of the Company's competitors or potential competitors have signiÑcantly greater Ñnancial, technical and marketing resources than the Company. As a result, they may be able to respond more quickly to new or emerging technologies and to changes in customer requirements, or to devote greater resources to the development, promotion and sale of their products than can the Company. In addition, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address the needs of the Company's prospective customers. Product Liability Software products such as those oÅered by the Company frequently contain undetected errors or failures when Ñrst introduced or as new versions are released. Testing of the Company's products is particularly challenging because it is diÇcult to simulate the wide variety of computing environments in which the Company's customers may deploy these products. Despite extensive testing, the Company from time to time has discovered defects or errors in products. There can be no assurance that such defects, errors or diÇculties will not cause delays in product introductions and shipments, result in increased costs and diversion of development resources, require design modiÑcations or decrease market acceptance or customer satisfaction with the Company's products or result in claims by customers against the Company. In addition, there can be no assurance that, despite testing by the Company and by current and potential customers, errors will not be found after commencement of commercial shipments, resulting in loss of or delay in market acceptance, which could have a material adverse eÅect upon the Company's business, operating results and Ñnancial condition. Backlog Backlog consists of Intersourcing and Base Hosting services sold under signed contracts for which the services have not yet been delivered. At December 31, 2004, the Company had backlog of $26.4 million 11 compared to $17.9 million as of December 31, 2003. The Company expects to Ñll $12.4 million of the backlog during 2005. The Company does not believe that backlog is a meaningful indicator of sales that can be expected for any future period. There can be no assurance that backlog at any point in time will translate into revenue in any subsequent period. Employees As of December 31, 2004, the Company employed 456 persons, including 65 in sales and marketing, 110 in professional services, 158 in research and development, 61 in customer support and 62 in Ñnance, information technology and administration. The Company believes that its relations with employees are good. However, competition for qualiÑed personnel in the Company's industry is generally intense and the management of the Company believes that its future success will depend in part on its continued ability to attract, hire and retain qualiÑed personnel. Available Information The Company's Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, proxy statements and amendments to those reports and any registration statements, included but not limited to, Form S-3 are available free of charge on our Internet website at www.ultimatesoftware.com as soon as reasonably practicable after such reports are electronically Ñled with the Securities and Exchange Commission. Information contained on Ultimate Software's website is not part of this report. Item 2. Properties Ultimate Software's corporate headquarters, including its principal administrative, marketing, engineer- ing and support operations, are located in three adjacent oÇce buildings in Weston, Florida. The Company leases all the available square footage in two buildings, or approximately 61,000 total square feet, under two leases, each expiring in 2017. In December 2004, the Company purchased, with available cash, all the available square footage of an adjacent building that serves as an extension of the Company's corporate headquarters, with approximately 5,000 square feet. In addition, the Company presently leases oÇce space for its sales operations in Albany, New York; Atlanta, Georgia; Columbia, Maryland; Dallas, Texas; Detroit, Michigan; Millburn, New Jersey; Nashville, Tennessee; Ridgeland, Mississippi; Seal Beach, California; and Schaumburg, Illinois. Sales operations in other locations are not supported by leased oÇce space. The Company believes that its existing facilities are suitable and adequate for its current operations for the next 12 months. The Company further believes that suitable space will be available as needed to accommodate any expansion of its operations on commercially reasonable terms. Item 3. Legal Proceedings From time-to-time, the Company is involved in litigation relating to claims arising out of its operations in the normal course of business. The Company is not currently a party to any legal proceedings the adverse outcome of which, individually or in the aggregate, could reasonably be expected to have a material adverse eÅect on the Company's operating results or Ñnancial condition. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the fourth quarter of 2004. 12 PART II Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters The following table sets forth, for the periods indicated, the high and low sales prices of the Company's Common Stock, as quoted on the Nasdaq National Market. 2004 2003 High Low High Low First QuarterÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Second Quarter ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Third Quarter ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Fourth Quarter ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $14.150 14.140 13.250 13.950 $ 8.500 9.900 9.710 11.670 $ 4.549 5.470 10.190 10.690 $3.060 3.610 4.900 8.020 As of February 18, 2005, the Company had approximately 167 holders of record, representing approximately 2,700 stockholder accounts. The Company has never declared or paid any cash dividends on its capital stock and does not anticipate paying any cash dividends in the foreseeable future. The Company currently intends to retain future earnings to fund the development and growth of its business. The payment of dividends in the future, if any, will be at the discretion of the Board of Directors. Under the terms of the Company's revolving line of credit with Silicon Valley Bank, the Company may not pay dividends without the prior written consent of Silicon Valley Bank. See ""Management's Discussion and Analysis of Financial Condition and Results of Operations Ì Liquidity and Capital Resources.'' 13 Item 6. Selected Financial Data The following selected consolidated Ñnancial data is qualiÑed by reference to and should be read in conjunction with ""Management's Discussion and Analysis of Financial Conditions and Results of Operations'' and the Company's Consolidated Financial Statements and Notes thereto included elsewhere in this Form 10-K. The statement of operations data presented below for each of the years in the three-year period ended December 31, 2004 and the balance sheet data as of December 31, 2004 and 2003 have been derived from the Company's Consolidated Financial Statements included elsewhere in this Form 10-K, which have been audited by KPMG LLP whose report appears elsewhere in this Form 10-K. The statement of operations data below for the years ended December 31, 2001 and December 2000 and the balance sheet data as of December 31, 2002, 2001 and 2000 have been derived from audited consolidated Ñnancial statements not included herein. 2004 Years Ended December 31, 2002 (In thousands, except per share data) 2003 2001 2000 Statement of Operations Data: Revenues: Recurring ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Services ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ LicenseÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Total revenuesÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $39,049 24,924 8,055 72,028 $29,344 23,478 7,594 60,416 $ 19,345 23,634 12,170 55,149 $14,364 28,289 16,826 59,479 $10,520 27,331 24,103 61,954 Cost of revenues: Recurring ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Services ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ LicenseÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Total cost of revenues ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 11,961 18,448 993 31,402 9,495 17,277 807 27,579 8,098 18,267 1,163 27,528 5,789 20,219 1,287 27,295 4,957 20,978 1,286 27,221 Operating expenses: Sales and marketing ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Research and development ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ General and administrative ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Total operating expenses ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Operating loss ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Interest expense ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Interest and other income ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 20,121 15,687 7,338 43,146 (8,413) (311) 320 Net loss ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $(5,024) $(9,169) $(14,568) $(8,750) $(8,404) 17,479 17,675 6,890 42,044 (14,423) (283) 138 17,788 18,229 5,871 41,888 (9,051) (221) 103 20,630 18,317 6,806 45,753 (5,127) (182) 285 18,261 12,775 10,065 41,101 (8,917) (208) 375 Net loss per share Ì basic and diluted(1) ÏÏÏÏ $ (0.23) $ (0.49) $ (0.90) $ (0.55) $ (0.52) Weighted average number of shares outstanding: Basic and diluted(1) ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 21,743 18,738 16,189 15,944 16,075 Balance Sheet Data: Cash and cash equivalentsÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Investments in marketable securities ÏÏÏÏÏÏÏÏÏ Total assets ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Deferred revenue ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Long-term borrowings, including capital lease obligations ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Stockholders' equity (deÑcit) ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $14,766 10,544 52,546 28,476 1,231 13,524 $13,783 Ó 35,812 24,610 $ 8,974 Ó 31,143 27,815 $ 8,464 Ó 34,251 20,215 $ 7,572 Ó 34,440 9,894 796 1,661 1,206 (7,368) 408 4,590 943 13,904 (1) See Note 2 of the Notes to Consolidated Financial Statements for information regarding the computation of net loss per share. 14 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion of the Ñnancial condition and results of operations of the Company contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements represent the Company's expectations or beliefs, including, but not limited to, statements concerning the Company's operations and Ñnancial performance and condition. Words such as ""anticipates,'' ""expects,'' ""intends,'' ""plans,'' ""believes,'' ""seeks,'' ""estimates,'' and similar expressions are intended to identify such forward-looking statements. These forward-looking statements are not guarantees of future performance and are subject to certain risks and uncertainties that are diÇcult to predict. The Company's actual results could diÅer materially from those contained in the forward-looking statements due to risks and uncertainties associated with Öuctuations in the Company's quarterly operating results, concentration of the Company's product oÅerings, development risks involved with new products and technologies, competition, the Company's contractual relationships with third parties, contract renewals with business partners, compliance by our customers with the terms of their contracts with us, and other factors disclosed in the Company's Ñlings with the Securities and Exchange Commission. Other factors that may cause such diÅerences include, but are not limited to, those discussed in this Form 10-K, including Exhibit 99.1 hereto. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Executive Summary Ultimate Software's UltiPro Workforce Management Software (""UltiPro'') is a Web-based solution designed to deliver the functionality businesses need to manage the employee life cycle, from recruiting and hiring to compensating and managing beneÑts to terminating, whether their processes are centralized at headquarters or distributed across multiple divisions or branch oÇces. The Company's main sources of revenues include sales from the Intersourcing OÅering (deÑned below), sales of perpetual software licenses for UltiPro (and the related annual maintenance) and sales of services (mostly implementation) related to both Intersourcing and license sales. In the past, the Company's primary business strategy was centered on sales of perpetual software licenses of UltiPro. In an eÅort to reduce the volatility and unpredictable nature of a business strategy predominantly focused on license sales, the Company introduced Intersourcing as an additional revenue source during 2002. In 2002, Ultimate Software began oÅering hosting services, branded ""Intersourcing'' by the Company, whereby Ultimate Software provides the hardware, infrastructure, ongoing maintenance and back-up services for its customers at a BellSouth data center managed by IBM. Intersourcing is designed to appeal to those customers that want to minimize their internal technology support requirements for the application and hardware. After the introduction of Intersourcing in mid-2002, the sales mix gradually began to shift towards Intersourcing, especially during 2003 and continuing in 2004. Management believes the shift in sales mix helps to produce a more predictable revenue stream by providing recurring revenue and cash from Intersourcing over the related contract periods, typically 24 months. As Intersourcing units are sold, the recurring revenue backlog associated with Intersourcing grows, enhancing the predictability of future revenue streams. For the last six months of 2003, the sales mix for number of units sold began shifting to favor Intersourcing units over license units, with this shift continuing into 2004. During the year ended December 31, 2004, the sales mix (for new units sold) was comprised of approximately 60% Intersourcing units and 40% license units, which reÖected a higher concentration of new Intersourcing units sold compared to the same period of 2003, when the sales mix (for new units sold) was comprised of 55% Intersourcing units and 45% license units. The Company expects the sales mix composition to continue to favor Intersourcing during 2005. The Ñnancial impact of the shift (from sales of license units to a combination of sales of license units and Intersourcing units) relates to (1) the type of revenue recognized and the timing of recognition; (2) the amount of services revenue recognized; and (3) the timing of cash received from the sale. 15 When an Intersourcing unit is sold instead of a license unit, license revenue is replaced with recurring revenue. The license revenue which would otherwise have been recognized upfront (assuming all required accounting criteria are met) is replaced with recurring revenue recognized over the contract term (typically 24 months) with such recurring revenue recognition commencing when the customer runs its Ñrst ""live'' payroll (i.e., generally between four and six months from the date of sale). The total revenue from the sale of an average Intersourcing unit sold is usually no less than it would have been if it were a license sale, with the main diÅerence pertaining to the period of recognition (i.e., being spread over a period of time rather than 100% upfront). In addition to the change in type of revenue and the timing of revenue recognition, implementation revenue (a component of services revenue) is also impacted by the shift in sales mix to Intersourcing. On average, an Intersourcing unit takes less time to implement than a license unit. Therefore, as the sales mix shifts towards Intersourcing, billable hours for the Company's implementation services per unit typically decrease. Cash is also impacted when an Intersourcing unit is sold instead of a license unit. For a typical license unit sale, the cash due for the license and the Ñrst year of annual maintenance is received within 9 months from the contract date. However, when an Intersourcing unit is sold, the cash due from the Intersourcing sale is received over the course of the contract term, typically 24 months. The total cash received from the sale of an average Intersourcing unit sold is usually no less than it would have been if it were a license sale with the main diÅerence pertaining to the period of time in which it is received. While making the transition from a business model focused solely on sales of perpetual licenses to a business model that includes both license sales and Intersourcing sales, the Company raised additional capital in 2004 and 2003 to address expected cash needs related to the transition. In May 2004, capital from a private placement of the Company's common stock, par value $0.01 per share (the ""Common Stock''), totaling $14.4 million, net of stock issuance costs, was raised to provide cash to fund future operations based on the Company's anticipated growth in Intersourcing sales. In 2003, capital from private placements of the Company's Common Stock, totaling $17.5 million, net of stock issuance costs, was raised to fund 2003 operations (including the impact of the transition toward more sales of Intersourcing units) and to provide cash to fund future operations based on the Company's anticipated growth in Intersourcing sales. As a result of the Company's recent transition to a sales mix favoring Intersourcing units, a key Ñnancial metric used by the Company in measuring future Ñnancial performance is new ""annual recurring revenues.'' New annual recurring revenues represent the expected one-year value from (i) new Intersourcing sales from the Company's hosted model (including prorated one-time charges); (ii) maintenance revenues related to new license sales; (iii) recurring revenues from new business service providers; and (iv) recurring revenues from additional sales to Ultimate Software's existing client base. New annual recurring revenues attributable to sales during 2004 were $12.0 million as compared to $9.2 million for 2003. Another major component of recurring revenues is subscription revenues generated from the Company's business service provider (""BSP'') channel. The BSP contributing the most revenues from the BSP Channel during each of 2004, 2003 and 2002 was Ceridian Corporation (""Ceridian'') under the Original Ceridian Agreement (deÑned below). See also ""OverviewÓOriginal Ceridian Agreement.'' As previously disclosed, Ultimate Software and Ceridian signed an agreement in 2001, as amended, granting Ceridian a non-exclusive license to use UltiPro software as part of an on-line oÅering for Ceridian to market primarily to businesses with less than 500 employees (the ""Original Ceridian Agreement''). Ceridian marketed that solution under the name SourceWeb. During December 2004, RSM McGladrey Employer Services (""RSM'') an existing business service provider of Ultimate Software's, acquired Ceridian's SourceWeb HR/payroll and self-service product and existing SourceWeb base of small and midsize business customers throughout the United States (the ""RSM Acquisition''). The Ñnancial terms of the Original Ceridian Agreement have not changed as a result of the RSM Acquisition. Ceridian will continue to be Ñnancially obligated to pay Ultimate Software a minimum fee of $500,000 per month with increases of 5% per annum, compounded beginning in January 2006. The aggregate minimum payments that Ceridian is obligated to pay Ultimate Software under the Original Ceridian Agreement over the minimum term of the agreement 16 are $42.7 million. To date, Ceridian has paid to Ultimate Software a total of $23.0 million under the Original Ceridian Agreement. Ultimate Software expects to continue to recognize a minimum of $642,000 per month in recurring subscription revenues from the Original Ceridian Agreement until its termination. The earliest date that this agreement can be terminated by either party is March 9, 2008 (except for an uncured material breach). The amount of subscription revenue, a component of recurring revenues, recognized under the Original Ceridian Agreement in 2004, totaling $7.7 million, was the same as that recognized in 2003. During 2004 and 2003, Ultimate Software entered into services agreements, as amended and extended from time to time, (individually, the ""Ceridian Services Agreement'' and collectively, the ""Ceridian Services Agreements''), with Ceridian. Under the Ceridian Services Agreements, Ceridian was obligated to pay Ultimate Software a total of $3.3 million and $2.3 million in 2004 and 2003, respectively, payable in equal quarterly installments, in exchange for additional services provided by Ultimate Software during the term of the agreements. The 2003 Ceridian Services Agreement expired eÅective December 31, 2003 and was recognized on a straight-line basis from February 10, 2003 through December 31, 2003. The 2004 Ceridian Services Agreement, as extended from time to time during 2004, expired on December 31, 2004 and was recognized on a straight-line basis from January 1, 2004 through December 31, 2004. The Company oÅers and provides certain services to other BSPs. Critical Accounting Policies and Estimates The preparation of Ñnancial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that aÅect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the Ñnancial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could diÅer from those estimates. Revenue Recognition Sources of revenue for the Company include: ‚ Sales of perpetual licenses for UltiPro; ‚ Sales of perpetual licenses for UltiPro in conjunction with services to host the UltiPro application (""Hosting Services''); ‚ Sales of the right to use UltiPro through ""Intersourcing'' (the ""Intersourcing OÅering''), which includes Hosting Services; ‚ Sales of Hosting Services on a stand-alone basis to customers who already own a perpetual license or are simultaneously acquiring a perpetual license for UltiPro (""Base Hosting''); ‚ Sales of services including implementation, training and other services, including the provision of payroll-related forms and the printing of Form W-2's for certain customers, as well as services provided to BSPs, including Ceridian through December 31, 2004 pursuant to the Ceridian Services Agree- ments; and ‚ Recurring revenues derived from (1) maintenance revenues generated from maintaining, supporting and providing periodic updates for the Company's software and (2) subscription revenues generated from per-employee-per-month (""PEPM'') fees earned through the Intersourcing OÅering, Base Hosting and the BSP sales channel, as well as revenues generated from the Original Ceridian Agreement. Perpetual Licenses for UltiPro Sold With or Without Hosting Services Sales of perpetual licenses for UltiPro and sales of perpetual licenses for UltiPro in conjunction with Hosting Services are multiple-element arrangements that involve the sale of software and consequently fall under the guidance of Statement of Position (""SOP'') 97-2, ""Software Revenue Recognition,'' for revenue recognition. 17 The Company licenses software under non-cancelable license agreements and provides services including maintenance, training and implementation consulting services. In accordance with the provisions of SOP 97-2, license revenues are generally recognized when (1) a non-cancelable license agreement has been signed by both parties, (2) the product has been shipped, (3) no signiÑcant vendor obligations remain and (4) collec- tion of the related receivable is considered probable. To the extent any one of these four criteria is not satisÑed, license revenue is deferred and not recognized in the consolidated statements of operations until all such criteria are met. For multiple-element software arrangements, each element of the arrangement is analyzed and the Company allocates a portion of the total fee under the arrangement to the elements based on vendor-speciÑc objective evidence of fair value of the element (""VSOE''), regardless of any separate prices stated within the contract for each element. Fair value is considered the price a customer would be required to pay when the element is sold separately. The Residual Method (as deÑned below) is used to recognize revenue when a license agreement includes one or more elements to be delivered at a future date and VSOE of the fair value of all undelivered elements exists. The fair value of the undelivered elements is determined based on the historical evidence of stand-alone sales of these elements to third parties. Undelivered elements in a license arrangement typically include maintenance, training and implementation services (the ""Standard Undelivered Elements''). The fair value for maintenance fees is based on the price of the services sold separately, which is determined by the annual renewal rate historically and consistently charged to customers (the ""Maintenance Valuation''). Maintenance fees are generally priced as a percentage of the related license fee. The fair value for training services is based on standard pricing (i.e., rate per training day charged to customers for class attendance), taking into consideration stand-alone sales of training services through year-end seminars and historically consistent pricing for such services (the ""Training Valuation''). The fair value for implementation services is based on standard pricing (i.e., rate per hour charged to customers for implementation services), taking into consideration stand-alone sales of implementation services through special projects and historically consistent pricing for such services (the ""Implementation Valuation''). Under the residual method (the ""Residual Method''), the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee attributable to the delivered element, the license fee, is recognized as revenue. If VSOE for one or more undelivered elements does not exist, the revenue is deferred on the entire arrangement until the earlier of the point at which (i) such VSOE does exist or (ii) all elements of the arrangement have been delivered. Perpetual licenses of UltiPro sold without Hosting Services typically include a license fee and the Standard Undelivered Elements. Fair value for the Standard Undelivered Elements is based on the Maintenance Valuation, the Training Valuation and the Implementation Valuation. The delivered element of the arrangement, the license fee, is accounted for in accordance with the Residual Method. Perpetual licenses of UltiPro sold with Hosting Services typically include a license fee, the Standard Undelivered Elements and Hosting Services. Fair value for the Standard Undelivered Elements is based on the Maintenance Valuation, the Training Valuation and the Implementation Valuation. Hosting Services are delivered to customers on a PEPM basis over the term of the related customer contract (""Hosting PEPM Services''). Upfront fees charged to customers represent fees for the hosting infrastructure, including hardware costs, third-party license fees and other upfront costs incurred by the Company in relation to providing such services (""Hosting Upfront Fees''). Hosting PEPM Services and Hosting Upfront Fees (collectively, ""Hosting Services'') represent undelivered elements in the arrangement since their delivery is over the course of the related contract term. The fair value for Hosting Services is based on standard pricing (i.e., rate charged per-employee-per-month), taking into consideration stand-alone sales of Hosting Services through the sale of such services to existing customers (i.e., those who already own the UltiPro perpetual license at the time Hosting Services are sold to them) and historically consistent pricing for such services (the ""Hosting Valuation''). The delivered element of the arrangement, the license fee, is accounted for in accordance with the Residual Method. The Company's customer contracts are non-cancelable agreements. The Company does not provide for rights of return or price protection on its software. The Company provides a limited warranty that its software 18 will perform in accordance with user manuals for varying periods, which are generally less than one year from the contract date. The Company's customer contracts generally do not include conditions of acceptance. However, if conditions of acceptance are included in a contract or uncertainty exists about customer acceptance of the software, license revenue is deferred until acceptance occurs. Sales Generated from the Intersourcing OÅering Subscription revenues generated from the Intersourcing OÅering are recognized in accordance with Emerging Issues Task Force (""EITF'') No. 00-21, ""Revenue Arrangements with Multiple Deliverables'' as a services arrangement since the customer is purchasing the right to use UltiPro rather than licensing the software on a perpetual basis. Fair value of multiple elements in Intersourcing arrangements is assigned to each element based on the guidance provided by EITF 00-21. The elements that typically exist in Intersourcing arrangements include hosting services, the right to use UltiPro, maintenance of UltiPro (i.e., product enhancements and customer support) and professional services (i.e., implementation services and training in the use of UltiPro). The pricing for hosting services, the right to use UltiPro and maintenance of UltiPro is bundled (the ""Bundled Elements''). Since these three Bundled Elements are components of recurring revenues in the consolidated statements of operations, allocation of fair values to each of the three elements is not necessary and they are not reported separately. Fair value for the Bundled Elements, as a whole, is based upon evidence provided by the Company's pricing for Intersourcing arrangements sold separately. The Bundled Elements are provided on an ongoing basis and represent undelivered elements under EITF 00-21; they are recognized on a monthly basis as the services are performed, once the customer has begun to process payrolls used to pay its employees (i.e., goes ""Live''). Implementation and training services (the ""Professional Services'') provided for Intersourcing arrange- ments are priced on a time and materials basis and are recognized as services revenue in the consolidated statements of operations as the services are performed. Under EITF 00-21, fair value is assigned to service elements in the arrangement based on their relative fair values, using the prices established when the services are sold on a stand-alone basis. Fair value for Professional Services is based on the respective Training Valuation and Implementation Valuation. If evidence of the fair value of one or more undelivered elements does not exist, the revenue is deferred and recognized when delivery of those elements occurs or when fair value can be established. The Company believes that applying EITF 00-21 to Intersourcing arrangements as opposed to applying SOP 97-2 is appropriate given the nature of the arrangements whereby the customer has no right to the UltiPro license. Sales of Base Hosting Services Subscription revenues generated from Base Hosting are recognized in accordance with EITF 00-3, ""Application of AICPA Statement of Position 97-2 to Arrangements that Include the Right to Use Software that Stored on Another Entity's Hardware,'' which provides guidance as to the application of SOP 97-2 to hosting arrangements that include a license right to the software. The elements that typically exist for Base Hosting arrangements include hosting services and implementation services. Base Hosting is diÅerent than Intersourcing arrangements in that the customer already owns a perpetual license or is purchasing a perpetual license for UltiPro and is purchasing hosting services subsequently in a separate transaction whereas, with Intersourcing, the customer is purchasing the right to use (not license) UltiPro. Implementation services provided for Base Hosting arrangements are substantially less than those provided for Intersourcing arrangements since UltiPro is already implemented in Base Hosting arrangements and only needs to be transitioned to a hosted environment. Fair value for hosting services is based on the Hosting Valuation. The fair value for implementation services is based on standard pricing (i.e., rate per hour charged to customers for implementation services), taking into consideration stand-alone sales of implementation services through special projects and historically consistent pricing for such services (the ""Implementation Valuation''). Fair value for implementation services is assigned in accordance with guidelines provided by SOP 97-2 based on the Implementation Valuation. 19 Services, including Implementation and Training Services Services revenues include revenues from fees charged for the implementation of the Company's software products and training of customers in the use of such products, fees for other services, including those related to the Ceridian Services Agreements through December 31, 2004, the provision of payroll-related forms and the printing of Form W-2's for certain customers, as well as certain reimbursable out-of-pocket expenses. Revenues for training and implementation consulting services are recognized as services are performed. Other services are recognized as the product is shipped or as the services are rendered depending on the speciÑc terms of the arrangement. Arrangement fees related to Ñxed-fee implementation services contracts are recognized using the percentage of completion accounting method, which involves the use of estimates. Percentage of completion is measured at each reporting date based on hours incurred to date compared to total estimated hours to complete. If a suÇcient basis to measure the progress towards completion does not exist, revenue is recognized when the project is completed or when we receive Ñnal acceptance from the customer. Recurring Revenues Recurring revenues include maintenance revenues and subscription revenues. Maintenance revenues are derived from maintaining, supporting and providing periodic updates for the Company's software. Subscription revenues are principally derived from PEPM fees earned through the Intersourcing OÅering, Base Hosting and the BSP sales channel, as well as revenues generated from the Original Ceridian Agreement. Maintenance revenues are recognized ratably over the service period, generally one year. Maintenance and support fees are generally priced as a percentage of the initial license fee for the underlying products. To the extent there are upfront fees associated with the Intersourcing OÅering, Base Hosting or the BSP sales channel, subscription revenues are recognized ratably over the term of the related contract upon the delivery of the product and services. In the cases of Intersourcing and Base Hosting sales, amortization of the upfront fees commences when the customer processes its Ñrst Live payroll, which typically occurs four to six months after the sale, and extends until the end of the contract period. In the case of BSP channel sales, amortization of the upfront fee typically commences when the contract is signed, which is when the BSP's rights under the agreement begin, continuing until the contract term ends. PEPM fees from the Intersourcing OÅering, Base Hosting and the BSP sales channel are recognized as subscription revenue as the services are delivered. Commencing on August 28, 2002, subscription revenues generated from the Original Ceridian Agreement are recognized ratably over the minimum term of the contract, which is expected to extend until March 9, 2008 (7 years from the eÅective date of the Original Ceridian Agreement). Subscription revenues of $642,000 per month are based on guaranteed minimum payments from Ceridian of approximately $42.7 million over the minimum contract term, including $23.0 million received to date. Maintenance services provided to customers include product updates and technical support services. Product updates are included in general releases to the Company's customers and are distributed on a periodic basis. Such updates may include, but are not limited to, product enhancements, payroll tax updates, additional security features or bug Ñxes. All features provided in general releases are unspeciÑed upgrade rights. To the extent speciÑed upgrade rights or entitlements to future products are included in a multi-element arrange- ment, revenue is recognized upon delivery provided fair value for the elements exists. In multi-element arrangements that include a speciÑed upgrade right or entitlement to a future product, if fair value does not exist for all undelivered elements, revenue for the entire arrangement is deferred until all elements are delivered or when fair value can be established. Subscription revenues generated from the BSP sales channel include both the right to use UltiPro and maintenance. The BSP is charged a fee on a per-employee-per-month basis and, in several cases, is subject to a guaranteed monthly minimum amount for the term of the related agreement. Revenue is recognized on a per-employee-per-month basis. To the extent the BSP pays the Company a one-time upfront fee, the Company accounts for such fee by recognizing it as subscription revenue over the minimum term of the related agreement. 20 The Company recognizes revenue in accordance with the Securities Exchange Commission (""SEC'') StaÅ Accounting Bulletin No. 101, ""Revenue Recognition in Financial Statements'' (""SAB No. 101'') and the SEC StaÅ Accounting Bulletin No. 104, ""Revenue Recognition'' (""SAB No. 104''). Management believes the Company is currently in compliance in all material aspects with the current provisions set forth in SOP 97-2, SOP 98-9, EITF 00-21, EITF 00-3, SAB No. 101 and SAB No. 104. Concentration of Revenues During the years ended December 31, 2004 and 2003, Ceridian accounted for 15.5% and 16.6%, respectively, of total revenues. Ceridian did not account for more than 10% of total revenues in 2002. No other customer accounted for more than 10% of total revenues in the periods presented. Due to the signiÑcant concentration of total revenues with this single customer, the Company has exposure if this customer loses its credit worthiness. The Ceridian Services Agreements, under which services revenues were recognized in 2004 and 2003, have terminated and no further services revenues will be recognized with respect to them. See Note 3 of the Notes to Consolidated Financial Statements. The composition of the revenues recognized from Ceridian, as a percentage of total revenues, for the years ended December 31, 2004, 2003 and 2002 was as follows: Recurring revenues ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Services revenuesÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 10.9% 12.8% 4.8% 4.6 3.8 Ì Total revenues ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 15.5% 16.6% 4.8% 2004 2003 2002 Allowance for Doubtful Accounts The Company maintains an allowance for doubtful accounts at an amount estimated to be suÇcient to provide adequate protection against losses resulting from collecting less than full payment on accounts receivable. In assessing the adequacy of the allowance for doubtful accounts, the Company considers multiple factors including historical bad debt experience, the general economic environment, and the aging of its receivables. A considerable amount of judgment is required when the realization of receivables is assessed, including assessing the probability of collection and current credit-worthiness of each customer. If the Ñnancial condition of the Company's customers were to deteriorate, resulting in an impairment of their ability to make payments, an additional provision for doubtful accounts may be required. Overview Ultimate Software designs, markets, implements and supports payroll and workforce management solutions. Ultimate Software's UltiPro Workforce Management Software (""UltiPro'') is a Web-based solution designed to deliver the functionality businesses need to manage the employee life cycle, from recruiting and hiring to compensating and managing beneÑts to terminating, whether their processes are centralized at headquarters or distributed across multiple divisions or branch oÇces. UltiPro's human resources (""HR'') and beneÑts management functionality is wholly integrated with a Öexible payroll engine, reporting and analytical decision-making tools, and a self-service Web portal for executives, managers, administrators, and employees to review and update work-related and personal information. Ultimate Software believes that UltiPro helps customers streamline HR and payroll processes to signiÑcantly reduce administrative and operational costs, while also empowering executives and staÅ to access critical information quickly and perform routine business activities eÇciently. UltiPro is marketed both through the Company's direct sales team as well as through alliances with business service providers (""BSPs'') that market co-branded UltiPro to their customer bases. Ultimate Software's direct sales team focuses primarily on companies with more than 500 employees and sells both a license model (typically in-house) and a service model (typically hosted and priced on a per-employee-per- 21 month basis). The Company's BSP alliances focus primarily on companies with under 500 employees and, since 2004, very large companies, generally those with over 10,000 employees, as well. The Company's BSP alliances typically sell an Internet solution, which includes UltiPro, priced on a monthly/service basis. When the BSP sells its Internet solution, incorporating UltiPro in the oÅering, the BSP is obligated to remit a fee to the Company, typically measured on a per-employee-per-month basis and, in some cases, subject to a guaranteed monthly minimum amount. The Company's direct sales force markets UltiPro as an in-house human resources, payroll and workforce management solution and alternatively as a hosted oÅering branded ""Intersourcing'' (the ""Intersourcing OÅering''). Intersourcing provides Web access to comprehensive workforce management functionality for organizations that need to simplify the information technology (""IT'') support requirements of their business applications. Ultimate Software believes that Intersourcing is attractive to companies that want to focus on their core competencies to increase sales and proÑts. Through the Intersourcing model introduced in 2002, the Company provides the hardware, infrastructure, ongoing maintenance and backup services for its customers at a BellSouth data center managed by International Business Machines (""IBM''). Intersourcing OÅering In 2002, the Company began oÅering a hosting service, branded Intersourcing, whereby the Company provides the hardware, infrastructure, ongoing maintenance and back-up services for its customers at a BellSouth data center, which is managed by IBM. DiÅerent types of hosting arrangements include the sale of hosting services as a part of the Intersourcing OÅering, discussed below, and, to a lesser extent, the sale of hosting services to customers that license UltiPro on a perpetual basis. Hosting services, typically available in a shared environment, provide Web access to comprehensive workforce management functionality for organizations that need to simplify the IT support requirements of their business applications and are priced on a per-employee-per-month basis. In the shared environment, Ultimate Software provides an infrastructure with applicable servers shared among many customers who use a Web browser to access the application software through the data center. The Intersourcing OÅering is designed to provide an appealing pricing structure to customers who prefer to minimize the initial cash outlay associated with typical capital expenditures. Intersourcing customers purchase the right to use UltiPro on an ongoing basis for a speciÑc term, typically in a shared environment. The pricing for Intersourcing, including both the hosting element as well as the right to use UltiPro, is on a per-employee-per-month basis. Original Ceridian Agreement During 2001, Ultimate Software and Ceridian reached an agreement, as amended in 2002, which granted Ceridian a non-exclusive license to use UltiPro software as part of an on-line oÅering that Ceridian can market primarily to businesses with under 500 employees (the ""Original Ceridian Agreement''). Ceridian marketed that solution under the name SourceWeb. Under the agreement, Ceridian is responsible for all marketing costs and expenses, and must sell the licensed software on a per period, per employee, per paycheck basis or other repetitive payment model. Ceridian is required to pay the Company a monthly license fee based on the number of employees paid using the licensed software. These payments are subject to a minimum monthly payment of $500,000 per month with increases of 5% per annum, compounded beginning in January 2006. The maximum monthly payment is $1.0 million, subject to increases of 5% per annum, compounded. The aggregate minimum payments that Ceridian is obligated to pay Ultimate Software under the Original Ceridian Agreement over the minimum term of the agreement is $42.7 million. To date, Ceridian has paid to Ultimate Software a total of $23.0 million under the Original Ceridian Agreement. The earliest date upon which the Ceridian Agreement can be terminated by either party (except for an uncured material breach) is March 9, 2008, resulting in an expected minimum term of 7 years. Ceridian retains certain rights to use the software upon termination. During December 2004, RSM McGladrey Employer Services (""RSM''), an existing business service provider of Ultimate Software's, acquired Ceridian's SourceWeb HR/payroll and self-service product and 22 existing SourceWeb base of small and midsize business customers throughout the United States (the ""RSM Acquisition''). The Ñnancial terms of the Original Ceridian Agreement have not changed as a result of the RSM Acquisition. Ceridian will continue to be Ñnancially obligated to pay Ultimate Software a minimum fee of $500,000 per month with increases of 5% per annum, compounded beginning in January 2006. Ultimate Software expects to continue to recognize a minimum of $642,000 per month in recurring subscription revenues from the Original Ceridian Agreement until its termination. Ceridian Services Agreements On April 7, 2004, the Company and Ceridian extended their services agreement, which expired on December 31, 2003 (the ""Extended Ceridian Services Agreement''). Under the Extended Ceridian Services Agreement, which was eÅective January 1, 2004 through September 30, 2004, Ceridian was obligated to pay Ultimate Software a total of $2.5 million in three equal installments in exchange for services provided by Ultimate Software during the term of that agreement. All three installment payments due under the Extended Services Agreement were received by the Company through July 2004. During October 2004, the Extended Ceridian Services Agreement was further extended until December 31, 2004 for a fee of $0.8 million, received in a single installment in November 2004. Services revenue from the Extended Ceridian Services Agreement was recognized on a straight-line basis from January 1, 2004 through December 31, 2004. The Extended Ceridian Services Agreement expired on December 31, 2004 and was not renewed. The Company oÅers and provides certain services to other BSPs. Results of Operations The following table sets forth the Statements of Operations data of the Company, as a percentage of total revenues, for the periods indicated. For the Years Ended December 31, 2003 2002 2004 Revenues: Recurring ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Services ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ License ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 54.2% 34.6 11.2 48.6% 38.8 12.6 35.1% 42.8 22.1 Total revenues ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 100.0 100.0 100.0 Cost of revenues: Recurring ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Services ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ License ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Total cost of revenuesÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Operating expenses: Sales and marketing ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Research and development ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ General and administrative ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Total operating expenses ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Operating loss ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Interest expenseÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Interest and other income ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 16.6 25.6 1.4 43.6 28.7 25.4 9.4 63.5 (7.1) (0.3) 0.4 15.7 28.6 1.3 45.6 29.4 30.2 9.7 14.7 33.1 2.1 49.9 31.7 32.1 12.5 69.3 (14.9) (0.4) 0.2 76.3 (26.2) (0.5) 0.3 Net loss ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ (7.0)% (15.1)% (26.4)% 23 Comparison of Fiscal Years Ended December 31, 2004 and 2003 Revenues The Company's revenues are derived from three principal sources: recurring revenues, services revenues and software licenses (""license revenues''). Recurring revenues include annual maintenance on software license agreements for the Company's products and subscription revenues. Maintenance revenues are derived from maintaining, supporting and providing periodic updates for the Company's software. Subscription revenues are principally derived from per-employee-per-month (""PEPM'') fees earned through the Intersourcing OÅering, Base Hosting and the BSP sales channel, as well as revenues generated from the Original Ceridian Agreement. Maintenance revenues are recognized ratably over the service period, generally one year. To the extent there are upfront fees associated with the Intersourcing OÅering, Base Hosting or the BSP sales channel, subscription revenues are recognized ratably over the term of the related contract upon the delivery of the product and services. PEPM fees from the Intersourcing OÅering, Base Hosting and the BSP sales channel are recognized as subscription revenues as the services are delivered. All of the Company's customers that purchased software during 2004 and 2003 also purchased maintenance and support service contracts. Maintenance and support fees are generally priced as a percentage of the initial license fee for the underlying products. Services revenues include revenues from fees charged for the implementation of the Company's software products and training of customers in the use of such products, fees for services provided to BSPs, including those related to the Ceridian Services Agreement (which expired on December 31, 2004), the provision of payroll-related forms and the printing of Form W-2's for certain customers and certain reimbursable out-of- pocket expenses. Revenues for training and implementation consulting services are recognized as services are performed. Revenues for the Ceridian Services Agreement were recognized ratably based on the terms of the agreement, from January 1, 2004 through December 31, 2004. Other services are recognized as the product is shipped or as the services are rendered. License revenues include revenues from software license agreements for the Company's products, entered into between the Company and its customers in which the license fees are non-cancelable. License revenues are generally recognized upon the delivery of the related software product when all signiÑcant contractual obligations have been satisÑed. Until such delivery, the Company records amounts received when contracts are signed as customer deposits which are included with deferred revenues in the consolidated balance sheets. Total revenues, consisting of recurring, services and license revenues, increased 19.2% to $72.0 million for 2004 from $60.4 million for 2003. Recurring revenues increased 33.1% to $39.0 million for 2004 from $29.3 million for 2003 primarily due to a total increase of $6.5 million in revenues generated from the Intersourcing OÅering resulting from incremental Intersourcing units sold and an increase in the number of Intersourcing customers that processed their Ñrst live payroll during 2004 combined with additional maintenance revenues generated from incremen- tal licenses sold. Recurring subscription revenues recognized in 2004 from the Original Ceridian Agreement, totaling $7.7 million, were the same as in 2003. Beginning on August 28, 2002, subscription revenues generated from the Original Ceridian Agreement of $642,000 per month have been recognized, and are expected to be recognized, over the minimum term of the contract. The earliest date upon which the Ceridian Agreement can be terminated by either party (except for an uncured material breach) is March 9, 2008, resulting in an expected minimum term of 7 years. Future recurring revenues to be recognized from the Original Ceridian Agreement are expected to be comparable to 2004, or $7.7 million per year through March 9, 2008. The impact on recurring revenues for units sold under the Intersourcing OÅering (as opposed to the impact on license revenues for licensed units sold) is expected to be gradual, based on the revenue recognition of the Intersourcing fees over the terms of the related contracts. The Company believes that a combination of units sold under the Intersourcing OÅering and regular licensed units sold will provide a more predictable business model in the future. Services revenues increased 6.2% to $24.9 million for 2004 from $23.5 million for 2003 primarily as a result of an increase of $1.1 million in services revenue generated from the Extended Ceridian Services 24 Agreement and an increase of $0.5 million in implementation revenues, partially oÅset by a decrease of $0.3 million in certain reimbursable out-of-pocket expenses. License revenues increased 6.1% to $8.0 million for 2004 from $7.6 million for 2003 primarily due to a higher average selling price in 2004 as unit sales were comparable. Cost of Revenues Cost of revenues consists of the cost of recurring, services and license revenues. Cost of recurring revenues consists of costs to provide maintenance and technical support to the Company's customers, the cost of providing periodic updates and the cost of subscription revenues, including amortization of capitalized software. Cost of services revenues primarily consists of costs to provide implementation services and training to the Company's customers and, to a lesser degree, costs related to sales of payroll-related forms, costs associated with certain reimbursable out-of-pocket expenses, discussed below, and costs to support additional services provided to BSPs. Cost of license revenues primarily consists of fees payable to a third-party for software products distributed by the Company and, to a lesser degree, amortization of capitalized software costs. UltiPro includes third-party software for enhanced report writing purposes. When UltiPro licenses are sold, customers pay the Company on a per user basis for the license rights to the third-party report writing software. Capitalized software is amortized using the straight-line method over the estimated useful life of the related asset, which is typically three years. Cost of recurring revenues increased 26.0% to $12.0 million for 2004 from $9.5 million for 2003. The $2.5 million increase in cost of recurring revenue for 2004 was attributable to additional costs associated with the growth in the Intersourcing OÅering, including labor costs, depreciation and amortization of related computer equipment and costs associated with the BellSouth data center. As a percentage of recurring revenues, cost of recurring revenues decreased to 30.6% for 2004 from 32.4% for 2003 primarily due to the absorption of these expenses in an expanded recurring revenue base. Cost of services revenues increased 6.8% to $18.4 million for 2004 from $17.3 million for 2003 primarily as a result of increased costs to provide additional services to BSPs, principally labor-related, and higher implementation and training costs, partially oÅset by a decrease in certain reimbursable out-of-pocket expenses. Cost of services revenues, as a percentage of services revenues, increased to 74.0% for 2004 from 73.6% for 2003 primarily as a result of higher expenses. Cost of license revenues increased 23% to $1.0 million for 2004 from $0.8 million for 2003. The increase in cost of license revenues for 2004 was due to increased labor costs and additional third-party royalty fees, partially oÅset by a reduction in the amortization of capitalized software. Capitalized software impacting the cost of license revenues were fully amortized as of July 31, 2004. As a percentage of license revenues, cost of license revenues increased to 12.3% for 2004 from 10.6% for 2003 primarily as a result of a disproportionate increase in the cost of licenses in comparison to the increase in the license revenue base. Cost of license revenues, as a percentage of license revenues, generally Öuctuates from period to period principally due to the mix of sales of software products which generate third-party license fees in each period and Öuctuations in revenues contrasted with Ñxed expenses such as labor costs and the amortization of capitalized software. Sales and Marketing Sales and marketing expenses consist primarily of salaries and beneÑts, sales commissions, travel and promotional expenses, and facility and communication costs for direct sales oÇces, as well as advertising and marketing costs. Sales and marketing expenses increased 16.0% to $20.6 million for 2004 from $17.8 million for 2003. The increase in sales and marketing expenses was primarily due to a $2.3 million increase in labor costs and, to a lesser extent, an increase in advertising and marketing costs of $0.5 million. The main contributing factors for the increase in labor costs in 2004 were sales commissions and salaries, beneÑts and travel costs. The increase in sales commissions was predominantly related to the increase in recurring revenues from Intersourcing, which are amortized over the initial term of the contracts, usually two years, commencing when the customer processes its Ñrst Live payroll. The addition of personnel to the sales infrastructure during 25 the three months ended September 30, 2003 was the primary cause for the increase in salaries, beneÑts and travel costs in 2004. Research and Development Research and development expenses consist primarily of software development personnel costs. Research and development expenses of $18.3 million in 2004 were consistent with expenses of $18.2 million in 2003 with 2004 labor costs increasing slightly over 2003. General and Administrative General and administrative expenses consist primarily of salaries and beneÑts of executive, administrative and Ñnancial personnel, as well as external professional fees and the provision for doubtful accounts. General and administrative expenses increased 15.9% to $6.8 million for 2004 from $5.9 million for 2003 primarily due to an increase of $0.6 million principally related to additional external professional fees associated with Sarbanes-Oxley Section 404 compliance and an increase of $0.2 million in the provision for doubtful accounts. Interest Expense Interest expense decreased 17.6% to $182,000 for 2004 from $221,000 for 2003 primarily due to the reduction in borrowings from the Credit Facility, deÑned below. Interest and Other Income Interest and other income increased 176.7% to $285,000 for 2004 from $103,000 for 2003 primarily due to interest income on cash available for investments. Provision for Income Taxes No provision or beneÑt for Federal, state or foreign income taxes was made for 2004 due to the operating losses and operating loss carryforwards from prior periods incurred in the respective periods. Net operating loss carryforwards available at December 31, 2004, expiring at various times through the year 2024 and which are available to oÅset future taxable income, were $62.9 million. The timing and levels of future proÑtability may result in the expiration of net operating loss carryforwards before utilization. Additionally, utilization of such net operating losses may be limited as a result of cumulative ownership changes in the Company's equity instruments. Comparison of Fiscal Years Ended December 31, 2003 and 2002 Revenues Total revenues, consisting of recurring, services and license revenues, increased to $60.4 million for 2003 from $55.1 million for 2002. Recurring revenues increased 51.7% to $29.3 million for 2003 from $19.3 million for 2002 primarily due to an increase of $5.0 million in subscription revenues recognized under the Original Ceridian Agreement, and a $4.7 million increase in recurring revenues generated from the Intersourcing OÅering resulting from additional Intersourcing units sold and maintenance revenues generated from incremental licenses sold. During 2003, there was an increase of $5.0 million in recurring revenues from the Original Ceridian Agreement in comparison to 2002. This increase was a result of the duration of revenue recognition in 2003 versus 2002 Ì in 2003, a full year of recurring revenues was recognized whereas in 2002 slightly more than four months of recurring revenues was recognized. Beginning on August 28, 2002, subscription revenues generated from the Original Ceridian Agreement of $642,000 per month have been, and are expected to be, recognized over the minimum term of the contract, which is expected to extend until March 9, 2008. Future recurring revenues to be recognized from the Original Ceridian Agreement are expected to be comparable to 2003, or $7.7 million per year, through March 9, 2008. 26 Services revenues decreased 0.7% to $23.5 million for 2003 from $23.6 million for 2002 primarily as a result of a decrease in implementation revenues of $2.7 million primarily resulting from fewer billable hours in 2003 principally caused by the shift towards Intersourcing units, which generally require less time to implement than license units, partially oÅset by an increase of $2.3 million in services revenue generated from the Ceridian Services Agreement, which were recognized ratably from February 10, 2003 through Decem- ber 31, 2003. License revenues decreased 37.6% to $7.6 million for 2003 from $12.2 million for 2002. The decrease in license revenues was due to the combination of fewer license units sold, principally due to a shift in targeted sales (i.e., a sales mix which includes more Intersourcing units sold), and a decrease in sales of UltiPro to existing clients using the Company's discontinued DOS-based product, UltiPro for Lan (""DOS Clients''). In the second half of 2002, the Company adjusted its sales and marketing strategy to include sales from its Intersourcing OÅering, which produces subscription revenues (a component of recurring revenues) rather than license revenues. In 2003, more units were sold from the Intersourcing OÅering than in the prior year. In addition, sales of the UltiPro product to DOS Clients ended during the last Ñscal quarter of 2002, shortly before support for UltiPro for Lan was discontinued (in January 2003). Prior to discontinuing support, the Company actively marketed the UltiPro product to DOS Clients as part of a loyalty program designed to encourage these clients to purchase UltiPro before support for UltiPro for Lan was discontinued. More than half of the DOS Clients converted to the UltiPro product in 2002. Cost of Revenues Cost of recurring revenues increased 17.3% to $9.5 million for 2003 from $8.1 million for 2002. The $1.4 million increase in cost of recurring revenue for 2003 was primarily attributable to additional costs associated with the Intersourcing OÅering, including depreciation and amortization of related computer equipment and costs associated with the BellSouth data center, and higher costs of maintenance revenues principally due to increased labor costs, including beneÑts. As a percentage of recurring revenues, cost of recurring revenues decreased to 32.4% for 2003 from 41.9% for 2002 primarily due to the absorption of these expenses in an expanded recurring revenue base. Cost of services revenues decreased 5.4% to $17.3 million for 2003 from $18.3 million for 2002. The decrease was due to a decrease of $0.7 million in costs of implementation, principally from lower third-party consultant fees and, to a lesser extent, a reduction in performance-based bonuses paid to Ultimate Software's consultants in 2003. Cost of services revenues, as a percentage of services revenues, decreased to 73.6% for 2003 from 77.3% for 2002 primarily as a result of lower expenses. Cost of license revenues decreased 30.6% to $0.8 million for 2003 from $1.2 million for 2002. The decrease in cost of license revenues for 2003 was due to lower third-party royalty fees resulting from fewer licensed units sold and a reduction in the amortization of capitalized software. As a percentage of license revenues, cost of license revenues increased to 10.6% for 2003 from 9.6% for 2002 primarily as a result of a decreased license revenue base. Cost of license revenues, as a percentage of license revenues, generally Öuctuates from period to period principally due to the mix of sales of software products which generate third- party license fees in each period and Öuctuations in revenues contrasted with Ñxed expenses such as labor costs and the amortization of capitalized software. Sales and Marketing Sales and marketing expenses increased 1.8% to $17.8 million for 2003 from $17.5 million for 2002. The increase in sales and marketing expenses was primarily due to a $0.8 million increase in labor costs, excluding sales commissions, and an increase in advertising and marketing costs of $0.2 million, partially oÅset by a decrease of $0.7 million attributable to lower sales commissions tied to the decrease in license revenues. The addition of personnel to the sales infrastructure during the three months ended September 30, 2003 was the main contributing factor for the increase in labor costs in 2003. 27 Research and Development Research and development expenses increased 3.1% to $18.2 million for 2003 from $17.7 million for 2002. The increase in 2003 was due to increased labor costs of $0.8 million principally resulting from increased beneÑt costs and additional personnel costs incurred as a result of the June 2003 acquisition of substantially all of the assets of Hireworks, Inc., a software company that developed, marketed and supported an Internet recruitment solution. General and Administrative General and administrative expenses decreased 14.8% to $5.9 million for 2003 from $6.9 million for 2002 primarily due to a $1.4 million reduction in the provision for doubtful accounts, partially oÅset by increased labor costs of $0.5 million. The provision for doubtful accounts decreased to $0.2 million for 2003 from $1.7 million in 2002. This decrease was primarily attributable to three factors: (1) a decrease of $1.6 million in the balance of accounts receivable, gross of the allowance for doubtful accounts; (2) a decrease of $2.4 million in individual accounts charged-oÅ during 2003 as compared to 2002; and (3) a decrease of $0.5 million in the allowance for doubtful accounts. The balance of gross accounts receivable declined principally due to a shift in targeted sales (i.e., a sales mix which includes more Intersourcing units sold). Intersourcing units typically have a shorter payment period than license units. Charge-oÅs were lower in 2003 due to the improvement in the quality of composition of the Company's accounts receivable portfolio. The allowance for doubtful accounts decreased as a result of the combination of the lower gross accounts receivable balance and the improvement of the quality of the composition of the accounts receivable portfolio in 2003 as compared to 2002. Interest Expense Interest expense decreased 21.9% to $221,000 for 2003 from $283,000 for 2002 primarily due to the payoÅ of outstanding borrowings under the Credit Facility (deÑned below) during September 2003. Interest and Other Income Interest and other income decreased 25.4% to $103,000 for 2003 from $138,000 for 2002 primarily due to the reduction in funds available for investment during the Ñrst half of 2003. Provision for Income Taxes No provision or beneÑt for Federal, state or foreign income taxes was made for 2003 due to the operating losses and operating loss carryforwards from prior periods incurred in the respective periods. Net operating loss carryforwards available at December 31, 2003, expiring at various times through the year 2023 and which are available to oÅset future taxable income, were $56.6 million. The timing and levels of future proÑtability may result in the expiration of net operating loss carryforwards before utilization. Additionally, utilization of such net operating losses may be limited as a result of cumulative ownership changes in the Company's equity instruments. Quarterly Results of Operations The following table sets forth certain unaudited quarterly results of operations for each of the quarters in the years ended December 31, 2004 and 2003. In management's opinion, this unaudited information has been prepared on the same basis as the audited consolidated Ñnancial statements and includes all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the information for the quarters presented. This information should be read in conjunction with the Company's Consolidated Financial Statements and Notes thereto, included elsewhere in this Form 10-K. The Company's quarterly revenues and operating results have varied signiÑcantly in the past and are likely to vary substantially from quarter to quarter in the future. The Company's operating results may Öuctuate as a result of a number of factors, including, but not limited to, increased expenses (especially as they 28 relate to product development and sales and marketing), timing of product releases, increased competition, variations in the mix of revenues, announcements of new products by the Company or its competitors and capital spending patterns of the Company's customers. The Company establishes its expenditure levels based upon its expectations as to future revenues, and, if revenue levels are below expectations, expenses can be disproportionately high. A drop in near term demand for the Company's products could signiÑcantly aÅect both revenues and proÑts in any quarter. Operating results achieved in previous Ñscal quarters are not necessarily indicative of operating results for the full Ñscal years or for any future periods. As a result of these factors, there can be no assurance that the Company will be able to establish or, when established, maintain proÑtability on a quarterly basis. The Company believes that, due to the underlying factors for quarterly Öuctuations, period-to-period comparisons of its operations are not necessarily meaningful and that such comparisons should not be relied upon as indications of future performance. Dec. 31, 2004 Sep. 30, 2004 Jun. 30, 2004 Mar. 31, 2004 Dec. 31, 2003 Sep. 30, 2003 Jun. 30, 2003 Mar. 31, 2003 Quarters Ended (Unaudited) (In thousands, except per share amounts) Revenues: RecurringÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $11,068 6,907 Services ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 2,533 License ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 20,508 Total revenuesÏÏÏÏÏÏÏÏÏÏ $10,075 6,079 2,011 18,165 $ 9,207 6,129 2,114 17,450 $ 8,699 5,809 1,397 15,905 $ 8,005 6,667 1,811 16,483 $ 7,364 5,440 2,506 15,310 $ 7,114 5,043 2,064 14,221 $ 6,861 6,328 1,213 14,402 Cost of revenues: RecurringÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Services ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ License ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Total cost of revenues ÏÏÏ 3,019 5,051 162 8,232 3,103 4,283 288 7,674 2,957 4,457 270 7,684 2,882 4,657 273 7,812 2,624 4,744 145 7,513 2,305 4,041 182 6,528 5,380 4,414 1,785 11,579 697 (49) 167 815 $ 5,158 4,805 1,894 11,857 (1,366) (34) 69 $(1,331) 5,261 4,543 1,669 11,473 (1,707) (70) 34 $(1,743) 4,831 4,555 1,458 10,844 (2,751) (29) 15 $(2,765) 4,991 4,566 1,480 11,037 (2,067) (43) 33 $(2,077) 4,499 4,807 1,480 10,786 (2,004) (50) 34 $(2,020) Operating expenses: Sales and marketingÏÏÏÏÏÏÏ Research and development General and administrative Total operating expenses Operating income (loss) Interest expense ÏÏÏÏÏÏÏÏÏÏÏÏ Interest and other income ÏÏÏÏ Net income (loss) ÏÏÏÏÏÏ Weighted average shares outstanding: Basic ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ DilutedÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 25,221 Net earnings (loss) per share: 22,447 22,353 22,353 21,479 21,479 20,680 20,680 20,550 20,550 20,110 20,110 17,515 17,515 16,718 16,718 Basic ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 0.04 $ (0.06) $ (0.08) $ (0.13) $ (0.10) $ (0.10) $ (0.14) $ (0.16) DilutedÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 0.03 $ (0.06) $ (0.08) $ (0.13) $ (0.10) $ (0.10) $ (0.14) $ (0.16) Liquidity and Capital Resources The Company has historically funded operations primarily through the private and public sale of equity securities and, to a lesser extent, equipment Ñnancing and borrowing arrangements. As of December 31, 2004, the Company had $25.3 million in cash, cash equivalents and investments in marketable securities, reÖecting a net increase of $11.5 million since December 31, 2003. As of December 31, 2004, the Company had working capital of $3.7 million as compared to a working capital deÑcit of $5.2 million as of December 31, 2003. The increase in working capital resulted primarily from the additional equity raised in 2004, partially oÅset by the funding of operations. Net cash provided by operating activities was $0.3 million for 2004 as compared to net cash used in operating activities of $8.7 million for 2003. The increase in net cash provided by operating activities was primarily due to cash received from Ceridian of $5.5 million, in accordance with the payment terms of the 29 2,275 4,057 237 6,569 4,209 4,527 1,293 10,029 (2,377) (75) 16 2,291 4,435 243 6,969 4,089 4,329 1,618 10,036 (2,603) (53) 20 $(2,436) $(2,636) Original Ceridian Agreement, partially oÅset by an increase in accounts receivable. In February 2002, the Company received $6.0 million from Ceridian as a prepayment by Ceridian of minimum guaranteed payments for 2003 due to the Company pursuant to the Original Ceridian Agreement, as amended from time to time, and the Company received $0.5 million in September 2002 for the early delivery of the general release, UltiPro 6.0 (also known as ""Evolution''). During 2003, the Company did not receive any cash from Ceridian under the Original Ceridian Agreement. Guaranteed minimum payments from Ceridian under the Original Ceridian Agreement of $500,000 per month resumed eÅective January 1, 2004. As of the date of this Form 10-K, the Company has received $1.0 million from Ceridian during 2005 pursuant to the payment terms of the Original Ceridian Agreement. In addition, during 2004, the Company received an additional $0.8 million from Ceridian pursuant to the Extended Ceridian Services Agreement, which expired on December 31, 2004. Net cash used in investing activities was $15.3 million for 2004 as compared to $2.3 million for 2003. The increase in net cash used in investing activities was primarily due to investing in marketable securities available-for-sale and an increase in purchases of property and equipment, including additional equipment purchases associated with the Intersourcing operations and the cash purchase in December 2004 of a 5,000 square foot building adjacent to the Company's headquarters which is being used to accommodate the growth in the Company's operations, partially oÅset by decrease in acquisitions. Net cash provided by Ñnancing activities was $16.0 million for 2004 as compared to $15.8 million for 2003. The increase in net cash provided by Ñnancing activities in 2004 as compared to 2003 was primarily related to increased borrowings under the equipment line of the Credit Facility, partially oÅset by a $1.6 million decrease in net proceeds from issuances of the Company's common stock, $0.01 par value per share (""Common Stock'') due to the combination of lower net proceeds from private sales of Common Stock and higher net proceeds from exercises of options to purchase Common Stock. For the year ended December 31, 2004, the Company had net borrowings of $0.4 million under the equipment line under the Credit Facility whereas in the year ended December 31, 2003, the Company had net repayments of $1.3 million under the Credit Facility. Days sales outstanding, calculated on a trailing three-month basis (""DSO''), as of December 31, 2004 and 2003, were 57 days and 52 days, respectively. The increase in DSO's as of December 31, 2004 was the result of an increase in accounts receivable attributable to higher license sales and certain BSP sales. Deferred revenue was $28.5 million at December 31, 2004 as compared to $24.6 million at December 31, 2003. The increase of $3.9 million in deferred revenue was primarily due to the combination of higher deferred Intersourcing revenues which are recognized over the term of the related contract and higher deferred revenue from several new BSP sales which are also recognized over the related contract term, partially oÅset by non- cash amortization of $1.7 million under the Original Ceridian Agreement. On May 12, 2004, the Company entered into a deÑnitive agreement to sell 1,398,182 newly issued shares of its Common Stock to three institutional investors in a private placement for gross proceeds of approximately $15.4 million (the ""Recent Capital Raised''). These shares of Common Stock were sold at $11.00 per share. After deducting commissions and other stock issuance costs, the Company received approximately $14.4 mil- lion. The Company is using the net proceeds from the Recent Capital Raised for general corporate purposes, including working capital and funding the Company's transition from a license model to a business model with a higher percentage of recurring revenues. The Company Ñled a registration statement with the Securities and Exchange Commission on Form S-3 (Registration No. 333-115894) covering resales of the Common Stock by investors, which registration statement was declared eÅective on June 25, 2004. On July 16, 2003, the Company sold 2,200,000 newly issued shares of its Common Stock to two institutional investors in a private placement for gross proceeds of approximately $11.7 million. These shares of Common Stock were sold at $5.30 per share. After deducting commissions and other stock issuance costs, the Company received approximately $10.6 million. The Company Ñled a registration statement with the Securities and Exchange Commission on Form S-3 (Registration No. 333-107527) covering resales of the Common Stock by investors, which registration statement was declared eÅective on December 9, 2003. 30 Certain other shareholders exercised their right to include shares owned by them in such registration statement on Form S-3. In addition to the July 16, 2003 private placement, during 2003 the Company sold an aggregate of 1,708,000 newly issued shares of Common Stock and warrants to purchase 170,800 shares of Common Stock at $4 per share to a group of investors, including Ceridian and some existing shareholders, for gross proceeds of $6.8 million. The Company's primary motive for raising additional capital in 2004 and 2003 was to fund the transition in its business model which shifts some of its UltiPro unit sales to Intersourcing. Management believes the shift in sales mix helps to produce a more predictable revenue stream by providing recurring revenue and cash from Intersourcing over the related contract periods, typically 24 months. As Intersourcing units are sold, the recurring revenue backlog associated with Intersourcing grows, providing visibility for the future and enhancing the predictability of future revenue streams. In November 2001, the Company entered into a $5.0 million revolving line of credit (the ""Credit Facility'') with Silicon Valley Bank. The Credit Facility, as amended, expires on May 27, 2005 and bears interest at a rate equal to Prime Rate plus 1.0% per annum (reduced to Prime Rate plus 0.5% per annum upon two consecutive quarters of net proÑtability, as deÑned). The Credit Facility provides working capital Ñnancing for up to 75% of the Company's eligible accounts receivable not to exceed $3.0 million (the ""Revolving Note''), as deÑned, stand-by letters of credit for up to $0.5 million as a component of the Revolving Note and Ñnancing for eligible equipment purchases for up to $2.0 million with additional limits for software purchases (the ""Equipment Term Note''). The Equipment Term Note is payable in 36 equal monthly installments, plus interest at Prime Rate plus 1%. The maximum amount available under the Credit Facility is $5.0 million. At December 31, 2004, $4.5 million was available for borrowing under the Credit Facility with $0.4 million outstanding under the Equipment Term Note. Borrowings under the Credit Facility are secured by all of the Company's corporate assets, including a negative pledge on intellectual property, and the Company is required to comply with certain Ñnancial and other covenants. Under the terms of the Credit Facility, the Company may not pay dividends without the prior written consent of Silicon Valley Bank. The material covenants require that the Company maintain, on a monthly basis, a minimum quick ratio (representing the ratio of current assets to current liabilities, excluding deferred revenue) of 1.75 to 1.0 and certain quarterly revenue levels as of the end of each quarter, as provided in the Credit Facility, as amended. As of December 31, 2004, the Company was in compliance with all covenants included in the terms of the Credit Facility. The Company believes that cash and cash equivalents and cash generated from operations will be suÇcient to fund its operations for at least the next 12 months. This belief is based upon, among other factors, management's expectations for future revenue growth, controlled expenses and collections of accounts receivable. Recent Accounting Literature In December 2004, the FASB issued SFAS No. 123 (revised 2004), ""Share-Based Payment'' (""SFAS 123R''), which replaces SFAS No. 123, ""Accounting for Stock-Based Compensation'' (""SFAS 123'') and supercedes APB Opinion No. 25, ""Accounting for Stock Issued to Employees.'' SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the Ñnancial statements based on their fair values and the recording of such expense in the consolidated statements of income. The accounting provisions of SFAS 123R are eÅective for reporting periods beginning after June 15, 2005. The pro forma disclosures previously permitted under SFAS 123, no longer will be an alternative to Ñnancial statement recognition. The Company is required to adopt SFAS 123R in the third quarter of Ñscal 2005. Under SFAS 123R, the Company must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. The Company is evaluating the requirements of SFAS 123R and expects that the adoption of SFAS 123R will have a material impact on the consolidated results of operations and earnings per share. The Company has not yet determined the method of adoption or the eÅect 31 of adopting SFAS 123R, and has not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS 123 in Note 2 of the Notes to Consolidated Financial Statements. In December 2003, the FASB issued a revised Interpretation No. 46, ""Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51,'' (""FIN 46R''). FIN 46R requires the consolidation of entities in which an enterprise absorbs a majority of the entity's expected losses, receives a majority of the entity's expected residual returns, or both, as a result of ownership, contractual or other Ñnancial interests in the entity. Currently entities are generally consolidated by an enterprise when it has a controlling Ñnancial interest through ownership of a majority voting interest in the entity. The provisions of FIN 46R are generally eÅective for existing (prior to February 1, 2003) variable interest relationships of a public entity no later than the end of the Ñrst reporting period that ends after March 15, 2004. However, prior to the required application of this interpretation a public entity that is not a small business issuer shall apply FIN 46R to those entities that are considered to be special-purpose entities no later than the end of the Ñrst reporting period that ends after December 15, 2003. The adoption of FIN 46R did not have an impact on the Company's consolidated Ñnancial statements. OÅ-Balance Sheet Arrangements The Company does not have any oÅ-balance sheet arrangements (as that term is deÑned in applicable SEC rules) that are reasonably likely to have a current or future material eÅect on the Company's Ñnancial condition, results of operations, liquidity, capital expenditures or capital resources. Contractual Obligations As of December 31, 2004, the Company's outstanding contractual cash obligations were as follows (in thousands): Capital lease obligations (1) ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Other long-term obligations (2) ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Purchase obligations (3)ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Other long-term liabilities (4) ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Payments Due by Period Less Than 1 Year 1-3 Years $ 990 1,775 Ì Ì $ 824 3,208 Ì 449 4-5 Years $ 153 2,968 Ì Ì After 5 Years $ Ì 9,216 Ì Ì Total $ 1,967 17,167 Ì 449 Total contractual cash obligations ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $19,583 $2,765 $4,481 $3,121 $9,216 (1) The Company leases certain equipment under non-cancellable agreements, which are accounted for as capital leases and expire at various dates through 2006. See Note 9 of the Notes to Consolidated Financial Statements for information regarding capital lease obligations. (2) The Company leases corporate oÇce space and certain equipment under non-cancellable operating lease agreements expiring at various dates. See Note 13 of the Notes to Consolidated Financial Statements for information regarding operating lease obligations. (3) Purchase orders or contracts for the purchase of goods and services are not included in the table above. The Company is not able to determine the aggregate amount of such purchase orders that represent contractual obligations, as purchase orders may represent authorizations to purchase rather than binding agreements. The Company does not have signiÑcant agreements for the purchase of goods or services specifying minimum quantities or set prices. (4) The Company has a $5.0 million revolving line of credit (the ""Credit Facility'') that expires on May 27, 2005. As of December 31, 2004, $0.4 million was outstanding under the Equipment Term Note of the Credit Facility, of which $0.3 million is classiÑed as long-term. See Note 10 of the Notes to Consolidated Financial Statements for information regarding long-term debt. There were no other long-term liabilities, other than those referred to in the table above, which were payable in cash. Other long-term liabilities in 32 the Company's consolidated balance sheet as of December 31, 2004 include deferred revenues which do not represent obligations payable in cash. See Note 2 of the Notes to Consolidated Financial Statements for information regarding deferred revenues. Item 7A. Quantitative and Qualitative Disclosures about Market Risk In the ordinary course of its operations, the Company is exposed to certain market risks, primarily interest rates. Uncertainties that are either non-Ñnancial or non-quantiÑable, such as political, economic, tax, other regulatory or credit risks are not included in the following assessment of the Company's market risks. Market risks. The Company manages market risk in accordance with its investment guideline objectives, including: ‚ Maximum safety of principal ‚ Maintenance of appropriate liquidity for regular cash needs ‚ Maximum yields in relationship to guidelines and market conditions ‚ DiversiÑcation of risks ‚ Fiduciary control of all investments The Company targets its portfolio to have maturities of twenty-four months or less. Investments are held to enhance the preservation of capital and not for trading purposes. Interest rates. Cash equivalents consist of money market accounts with original maturities of less than three months. Short-term investments include obligations of U.S. government agencies and corporate debt securities with ratings of at least doubleÓA by Moody's or Standard and Poor, which limits credit risk. Interest on the Credit Facility, as amended, which expires on May 28, 2005, is based on Prime Rate plus 1.0% per annum (reduced to Prime Rate plus 0.5% per annum upon two consecutive quarters of net proÑtability, as deÑned). As of December 31, 2004, $4.5 million was available for borrowing under the Credit Facility with $0.4 million outstanding under the Equipment Term Note. As of December 31, 2004, total investments in marketable securities were $10.5 million. Changes in amounts borrowed or interest rates could impact the Company's anticipated interest income from interest-bearing cash accounts, or cash equivalents, investments in marketable securities, as well as interest expense on borrowings under the Credit Facility. Item 8. Financial Statements and Supplementary Data INDEX Report of Independent Registered Public Accounting Firm ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Consolidated Balance Sheets as of December 31, 2004 and 2003 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Consolidated Statements of Operations for the Years Ended December 31, 2004, 2003 and 2002 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Consolidated Statements of Stockholders' Equity (DeÑcit) for the Years Ended December 31, 2004, 2003 and 2002 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Consolidated Statements of Cash Flows for the Years Ended December 31, 2004, 2003 and 2002 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Notes to Consolidated Financial Statements ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Page(s) 34 35 36 37 38 39 33 Report of Independent Registered Public Accounting Firm The Board of Directors and Stockholders The Ultimate Software Group, Inc.: We have audited the accompanying consolidated balance sheets of The Ultimate Software Group, Inc. and subsidiary (the ""Company'') as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders' equity (deÑcit), and cash Öows for each of the years in the three-year period ended December 31, 2004. These consolidated Ñnancial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated Ñnancial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the Ñnancial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the Ñnancial statements. An audit also includes assessing the accounting principles used and signiÑcant estimates made by management, as well as evaluating the overall Ñnancial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated Ñnancial statements referred to above present fairly, in all material respects, the Ñnancial position of the Company as of December 31, 2004 and 2003, and the results of their operations and their cash Öows for each of the years in the three-year period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the eÅectiveness of the Company's internal control over Ñnancial reporting as of December 31, 2004, based on criteria established in Internal Control Ó Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 10, 2005, expressed an unqualiÑed opinion on management's assessment of, and the eÅective operation of, internal control over Ñnancial reporting. /s/ KPMG LLP KPMG LLP Miami, Florida March 10, 2005 34 THE ULTIMATE SOFTWARE GROUP, INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS As of December 31, 2004 2003 (In thousands, except share data) Current assets: ASSETS Cash and cash equivalents ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Accounts receivable, net of allowance for doubtful accounts of $500 and $525 for 2004 and 2003, respectively ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Short-term investments in marketable securities ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Prepaid expenses and other current assets ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Total current assets ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Property and equipment, netÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Capitalized software, net ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Long-term investments in marketable securities ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Other assets, netÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 14,766 $ 13,783 12,600 8,103 3,114 38,583 9,512 82 2,441 1,928 9,292 Ì 2,709 25,784 7,188 1,234 Ì 1,606 Total assets ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 52,546 $ 35,812 Current liabilities: LIABILITIES AND STOCKHOLDERS' EQUITY Accounts payable ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Accrued expensesÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Current portion of deferred revenueÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Current portion of long-term debt ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Current portion of capital lease obligationsÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ Total current liabilities ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Capital lease obligations, net of current portion ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Long-term debt, net of current portion ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Deferred revenue, net of current portion ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Total liabilities ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 2,202 6,015 25,591 170 928 34,906 952 279 2,885 39,022 $ 2,549 5,378 22,277 Ì 818 31,022 796 Ì 2,333 34,151 Commitments and contingencies (Note 13) Stockholders' equity: Series A Junior Participating Preferred Stock, $.01 par value, 500,000 shares authorized, no shares issued ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Preferred Stock, $.01 par value, 2,000,000 shares authorized, no shares issued ÏÏÏ Common Stock, $.01 par value, 50,000,000 shares authorized, 22,749,363 and 20,843,935 shares issued in 2004 and 2003, respectively ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Additional paid-in capital ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Accumulated comprehensive lossÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Accumulated deÑcitÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Treasury stock, at cost, 257,647 shares ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Ì Ì Ì Ì 227 103,643 (15) (89,277) 14,578 (1,054) 208 86,760 Ì (84,253) 2,715 (1,054) 1,661 Total stockholders' equity ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 13,524 Total liabilities and stockholders' equity ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 52,546 $ 35,812 The accompanying Notes to Consolidated Financial Statements are an integral part of these Ñnancial statements. 35 THE ULTIMATE SOFTWARE GROUP, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF OPERATIONS For the Years Ended December 31, 2002 2003 (In thousands, except per share amounts) 2004 Revenues: Recurring ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Services ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ License ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $39,049 24,924 8,055 Total revenues ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 72,028 $29,344 23,478 7,594 60,416 $ 19,345 23,634 12,170 55,149 Cost of revenues: Recurring ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Services ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ License ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 11,961 18,448 993 Total cost of revenuesÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 31,402 Sales and marketing ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Research and development ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ General and administrative ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 20,630 18,317 6,806 Total operating expenses ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 45,753 9,495 17,277 807 27,579 17,788 18,229 5,871 41,888 8,098 18,267 1,163 27,528 17,479 17,675 6,890 42,044 Operating loss ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ (5,127) (9,051) (14,423) Interest expenseÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Interest and other income ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ (182) 285 (221) 103 (283) 138 Net loss ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $(5,024) $(9,169) $(14,568) Net loss per share Ì basic and diluted ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ (0.23) $ (0.49) $ (0.90) Weighted average shares outstanding: Basic and dilutedÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 21,743 18,738 16,189 The accompanying Notes to Consolidated Financial Statements are an integral part of these Ñnancial statements. 36 THE ULTIMATE SOFTWARE GROUP, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) (In thousands) Common Stock Shares Amount Additional Paid-in Capital Accumulated Comprehensive Accumulated Treasury Stock $161 Ì $ 65,808 Ì Balance, December 31, 2001 ÏÏ 16,106 Net lossÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Ì Issuances of Common Stock from exercise of stock optionsÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 7 Issuance of Common Stock from private placement ÏÏÏÏÏ 675 Non-cash issuances of options to Board to purchase Common Stock for board fees ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Purchase of Treasury Stock ÏÏÏ Ì Ì Balance, December 31, 2002 ÏÏ 16,788 Net lossÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Ì Issuances of Common Stock from exercise of stock options and warrant ÏÏÏÏÏÏÏÏ Issuance of Common Stock for private placementÏÏÏÏÏÏÏÏÏÏ 3,908 148 Non-cash issuances of options to Board to purchase Common Stock for board fees ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Ì Balance, December 31, 2003 ÏÏ 20,844 Ì Net lossÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Unrealized loss on investments in marketable securities available-for-sale ÏÏÏÏÏÏÏÏÏÏ Comprehensive loss ÏÏÏÏÏÏÏÏÏÏ Ì Ì Issuances of Common Stock from exercise of stock options and warrants ÏÏÏÏÏÏÏ Issuance of Common Stock for private placementÏÏÏÏÏÏÏÏÏÏ Non-cash issuances of options to Board to purchase Common Stock for board fees ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 507 1,398 Ì 7 Ì Ì 168 Ì 1 39 Ì 208 Ì Ì Ì 5 14 Loss $ Ì Ì Ì Ì Ì Ì Ì Ì Ì Ì Ì Ì Ì 17 2,693 84 Ì 68,602 Ì 571 17,455 132 86,760 Ì Ì Ì (15) Ì 2,287 14,319 Ì Ì Ì Ì 141 Ì Non-cash compensation expense for stock option modiÑcations ÏÏÏÏÏÏÏÏÏÏÏÏÏ Ì Balance, December 31, 2004 ÏÏ 22,749 Ì $227 136 $103,643 Ì $(15) DeÑcit Shares Amount $(60,516) (14,568) Ì Ì Ì Ì (75,084) (9,169) Ì Ì Ì (84,253) (5,024) Ì Ì Ì Ì Ì Ì $(89,277) 211 Ì Ì Ì Ì 47 258 Ì Ì Ì Ì 258 Ì Ì Ì Ì Ì Ì Ì 258 $ (863) Ì Ì Ì Ì (191) (1,054) Ì Ì Ì Ì (1,054) Ì Ì Ì Ì Ì Ì Ì $(1,054) Total Stockholders' Equity $ 4,590 (14,568) 17 2,700 84 (191) (7,368) (9,169) 572 17,494 132 1,661 (5,024) (15) (5,039) 2,292 14,333 141 136 $ 13,524 The accompanying Notes to Consolidated Financial Statements are an integral part of these Ñnancial statements. 37 THE ULTIMATE SOFTWARE GROUP, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 2002 2003 2004 (In thousands) $ (5,024) $(9,169) $(14,568) Cash Öows from operating activities: Net loss ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Depreciation and amortizationÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Provision for doubtful accounts ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Non-cash issuances of options to Board to purchase Common Stock for board fees ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Non-cash compensation expense for stock option modiÑcations ÏÏÏÏ Changes in operating assets and liabilities: Accounts receivable ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Prepaid expenses and other current assets ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Other assets ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Accounts payable ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Accrued expenses ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Deferred revenueÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 5,055 419 141 136 (3,727) (405) (471) (347) 637 3,866 5,032 213 132 Ì 876 (1,436) (838) (144) (151) (3,205) (8,690) Net cash provided by (used in) operating activities ÏÏÏÏÏÏÏÏ 280 Cash Öows from investing activities: Purchases of marketable securities ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Purchases of property and equipmentÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ AcquisitionÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ (10,560) (4,695) Ì Ì (1,953) (350) Net cash used in investing activitiesÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ (15,255) (2,303) Cash Öows from Ñnancing activities: Principal payments on capital lease obligations ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Net proceeds from issuances of Common StockÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Net borrowings (repayments) under Credit FacilityÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Purchases of Treasury Stock ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Net cash provided by Ñnancing activities ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Net increase in cash and cash equivalents ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Cash and cash equivalents, beginning of year ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ (1,116) 16,625 449 Ì 15,958 983 13,783 (918) 18,066 (1,346) Ì 15,802 4,809 8,974 Cash and cash equivalents, end of year ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 14,766 $13,783 $ 8,974 Supplemental disclosure of cash Öow information: Cash paid for interest ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 72 $ 144 $ 216 Supplemental disclosure of non-cash investing and Ñnancing activities: Ó The Company entered into capital lease obligations to acquire new equipment totaling $1,382, $1,404 and $1,007 in 2004, 2003 and 2002, respectively The accompanying Notes to Consolidated Financial Statements are an integral part of these Ñnancial statements. 38 5,838 1,657 84 Ì 1,968 (437) (138) 792 (19) 7,600 2,777 Ì (4,263) Ì (4,263) (1,876) 2,717 1,346 (191) 1,996 510 8,464 THE ULTIMATE SOFTWARE GROUP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. NATURE OF OPERATIONS The Ultimate Software Group, Inc. (""Ultimate Software'' or the ""Company'') designs, markets, implements and supports payroll and workforce management solutions, marketed primarily to middle-market organizations with 500 to 15,000 employees. The Company reaches its customer base and target market through its direct sales force and a network of national, regional and local strategic partners. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Consolidation The consolidated Ñnancial statements include the accounts of the Company and its subsidiary, Ultimate BeneÑts, Inc., an inactive company. Intercompany accounts and transactions have been eliminated in consolidation. Cash and Cash Equivalents All highly liquid instruments with an original maturity of three months or less when acquired are considered cash equivalents and are comprised of interest-bearing accounts. Accounts Receivable Accounts receivable are principally from end-users of the Company's products. The Company performs credit evaluations of its customers and has recorded allowances for estimated losses. The Company maintains an allowance for doubtful accounts at an amount estimated to be suÇcient to provide adequate protection against losses resulting from collecting less than full payment on accounts receivables. A considerable amount of judgment is required when the realization of receivables is assessed, including assessing the probability of collection and current credit-worthiness of each customer. If the Ñnancial condition of the Company's customers were to deteriorate, resulting in an impairment of their ability to make payments, an additional provision for doubtful accounts may be required. Investments in Marketable Securities The Company classiÑes its investments in marketable securities with readily determinable fair values as securities available-for-sale in accordance with Statement of Financial Accounting Standards No. 115, ""Accounting for Certain Investments in Debt and Equity Securities'' (""FAS 115''). The Company has classiÑed all investments as available-for-sale. Available-for-sale securities consist of debt and equity securities not classiÑed as trading securities nor as securities to be held to maturity. Unrealized holding gains and losses on securities available-for-sale are reported as a net amount in accumulated other comprehensive loss in stockholders' equity until realized. Gains and losses on the sale of securities available-for-sale are determined using the speciÑc identiÑcation method. 39 The amortized cost and market value of the Company's investments in available-for-sale securities at December 31, 2004 are shown in the table below. There were no such investments held at December 31, 2003 or during the Ñscal year then ended (in thousands). Amortized Cost Gross Unrealized Gain Gross Unrealized Loss Market Value Investments in marketable securities: U.S. government obligations ÏÏÏÏÏÏÏÏÏ Corporate debt securities ÏÏÏÏÏÏÏÏÏÏÏÏ $ 5,863 4,697 $ Ì Ì Cash equivalents: U.S. government obligations ÏÏÏÏÏÏÏÏÏ Corporate debt securities ÏÏÏÏÏÏÏÏÏÏÏÏ 10,560 3,631 2,520 6,151 Ì 1 Ì 1 $ 6 10 16 Ì Ì Ì $ 5,857 4,687 10,544 3,632 2,520 6,152 Total investments, available-for-sale ÏÏÏÏÏ $16,711 $ 1 $16 $16,696 The amortized cost and estimated fair value of the available-for-sale securities by contractual maturity at December 31, 2004 are shown below (in thousands): Amortized Cost Estimated Fair Value Due in one year or lessÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Due after one year ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $14,261 2,450 $14,255 2,441 Total ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $16,711 $16,696 Property and Equipment Property and equipment is stated at cost, net of accumulated depreciation and amortization. Property and equipment is depreciated using the straight-line method over the estimated useful lives of the assets, which range from two to twenty years. Leasehold improvements and assets under capital leases are amortized over the shorter of the life of the asset or the term of the lease over periods ranging from two to Ñfteen years. Maintenance and repairs are charged to expense when incurred; betterments are capitalized. Upon the sale or retirement of assets, the cost, accumulated depreciation and amortization are removed from the accounts and any gain or loss is recognized. Revenue Recognition Sources of revenue for the Company include: ‚ Sales of perpetual licenses for UltiPro Workforce Management Software (""UltiPro''), a Web-based solution designed to deliver the functionality businesses need to manage the employee life cycle, whether their processes are centralized at headquarters or distributed across multiple divisions or branch oÇces; ‚ Sales of perpetual licenses for UltiPro in conjunction with services to host the UltiPro application (""Hosting Services''); ‚ Sales of the right to use UltiPro, including Hosting Services (the ""Intersourcing OÅering''); ‚ Sales of Hosting Services on a stand-alone basis to customers who already own a perpetual license or are simultaneously acquiring a perpetual license for UltiPro (""Base Hosting''); ‚ Sales of other services including implementation, training and other services, including the provision of payroll-related forms and the printing of Form W-2's for certain customers, as well as services provided 40 to business service providers (""BSPs'') in 2004 and 2003,principally Ceridian Corporation (""Cer- idian'') pursuant to the Ceridian Services Agreements (deÑned below); and ‚ Recurring revenues derived from (1) maintenance revenues generated from maintaining, supporting and providing periodic updates for the Company's software and (2) subscription revenues generated from per-employee-per-month (""PEPM'') fees earned through the Intersourcing OÅering, Base Hosting and the business service provider (""BSP'') sales channel, as well as revenues generated from the Original Ceridian Agreement (deÑned below). Perpetual Licenses for UltiPro Sold With or Without Hosting Services Sales of perpetual licenses for UltiPro and sales of perpetual licenses for UltiPro in conjunction with Hosting Services are multiple-element arrangements that involve the sale of software and consequently fall under the guidance of Statement of Position (""SOP'') 97-2, ""Software Revenue Recognition,'' for revenue recognition. The Company licenses software under non-cancelable license agreements and provides services including maintenance, training and implementation consulting services. In accordance with the provisions of SOP 97-2 license revenues are generally recognized when (1) a non-cancelable license agreement has been signed by both parties, (2) the product has been shipped, (3) no signiÑcant vendor obligations remain and (4) collec- tion of the related receivable is considered probable. To the extent any one of these four criteria is not satisÑed, license revenue is deferred and not recognized in the consolidated statement of operations until all such criteria are met. For multiple-element software arrangements, each element of the arrangement is analyzed and the Company allocates a portion of the total fee under the arrangement to the elements based on vendor-speciÑc objective evidence of fair value of the element (""VSOE''), regardless of any separate prices stated within the contract for each element. Fair value is considered the price a customer would be required to pay when the element is sold separately. The residual method is used to recognize revenue when a license agreement includes one or more elements to be delivered at a future date and VSOE of the fair value of all undelivered elements exists. The fair value of the undelivered elements is determined based on the historical evidence of stand-alone sales of these elements to third parties. Undelivered elements in a license arrangement typically include maintenance, training and implementation services (the ""Standard Undelivered Elements''). The fair value for maintenance fees is based on the price of the services sold separately, which is determined by the annual renewal rate historically and consistently charged to customers (the ""Maintenance Valuation''). Maintenance fees are generally priced as a percentage of the related license fee. The fair value for training services is based on standard pricing (i.e., rate per training day charged to customers for class attendance), taking into consideration stand-alone sales of training services through year-end seminars and historically consistent pricing for such services (the ""Training Valuation''). The fair value for implementation services is based on standard pricing (i.e., rate per hour charged to customers for implementation services), taking into consideration stand-alone sales of implementation services through special projects and historically consistent pricing for such services (the ""Implementation Valuation''). Under the residual method (the ""Residual Method''), the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee attributable to the delivered element, the license fee, is recognized as revenue. If VSOE for one or more undelivered elements does not exist, the revenue is deferred on the entire arrangement until the earlier of the point at which (i) such VSOE does exist or (ii) all elements of the arrangement have been delivered. Perpetual licenses of UltiPro sold without Hosting Services typically include a license fee and the Standard Undelivered Elements. Fair value for the Standard Undelivered Elements is based on the Maintenance Valuation, the Training Valuation and the Implementation Valuation. The delivered element of the arrangement, the license fee, is accounted for in accordance with the Residual Method. Perpetual licenses of UltiPro sold with Hosting Services typically include a license fee, the Standard Undelivered Elements and Hosting Services. Fair value for the Standard Undelivered Elements is based on 41 the Maintenance Valuation, the Training Valuation and the Implementation Valuation. Hosting Services are delivered to customers on a PEPM basis over the term of the related customer contract (""Hosting PEPM Services''). Upfront fees charged to customers represent fees for the hosting infrastructure, including hardware costs, third-party license fees and other upfront costs incurred by the Company in relation to providing such services (""Hosting Upfront Fees''). Hosting PEPM Services and Hosting Upfront Fees (collectively, ""Hosting Services'') represent undelivered elements in the arrangement since their delivery is over the course of the related contract term. The fair value for Hosting Services is based on standard pricing (i.e., rate charged per-employee-per-month), taking into consideration stand-alone sales of Hosting Services through the sale of such services to existing customers (i.e., those who already own the UltiPro perpetual license at the time Hosting Services are sold to them) and historically consistent pricing for such services (the ""Hosting Valuation''). The delivered element of the arrangement, the license fee, is accounted for in accordance with the Residual Method. The Company's customer contracts are non-cancelable agreements. The Company does not provide for rights of return or price protection on its software. The Company provides a limited warranty that its software will perform in accordance with user manuals for varying periods, which are generally less than one year from the contract date. The Company's customer contracts generally do not include conditions of acceptance. However, if conditions of acceptance are included in a contract or uncertainty exists about customer acceptance of the software, license revenue is deferred until acceptance occurs. Sales Generated from the Intersourcing OÅering Subscription revenues generated from the Intersourcing OÅering, are recognized in accordance with Emerging Issues Task Force (""EITF'') No. 00-21, ""Revenue Arrangements with Multiple Deliverables'' as a services arrangement since the customer is purchasing the right to use UltiPro rather than licensing the software on a perpetual basis. Fair value of multiple elements in Intersourcing arrangements is assigned to each element based on the guidance provided by EITF 00-21. The elements that typically exist in Intersourcing arrangements include hosting services, the right to use UltiPro, maintenance of UltiPro (i.e., product enhancements and customer support) and professional services (i.e., implementation services and training in the use of UltiPro). The pricing for hosting services, the right to use UltiPro and maintenance of UltiPro is bundled (the ""Bundled Elements''). Since these three Bundled Elements are components of recurring revenues in the consolidated statements of operations, allocation of fair values to each of the three elements is not necessary and they are not reported separately. Fair value for the Bundled Elements, as a whole, is based upon evidence provided by the Company's pricing for Intersourcing arrangements sold separately. The Bundled Elements are provided on an ongoing basis and represent undelivered elements under EITF 00-21; they are recognized on a monthly basis as the services are performed, once the customer has begun to process payrolls used to pay its employees (i.e., goes ""Live''). Implementation and training services (the ""Professional Services'') provided for Intersourcing arrange- ments are priced on a time and materials basis and are recognized as services revenue in the consolidated statements of operations as the services are performed. Fair value for Professional Services is based on the respective Training Valuation and Implementation Valuation. Under EITF 00-21, fair value is assigned to service elements in the arrangement based on their relative fair values, using the prices established when the services are sold on a stand-alone basis. If evidence of the fair value of one or more undelivered elements does not exist, the revenue is deferred and recognized when delivery of those elements occurs or when fair value can be established. The Company believes that applying EITF 00-21 to Intersourcing arrangements as opposed to applying SOP 97-2 is appropriate given the nature of the arrangements whereby the customer has no right to the UltiPro license. Sales of Base Hosting Services Subscription revenues generated from Base Hosting are recognized in accordance with EITF 00-3, ""Application of AICPA Statement of Position 97-2 to Arrangements That Include the Right to Use Software Stored on Another Entity's Hardware,'' which provides guidance as to the application of SOP 97-2 to hosting 42 arrangements that include a license right to the software. The elements that typically exist for Base Hosting arrangements include hosting services and implementation services. Base Hosting is diÅerent than Intersourc- ing arrangements (described above) in that the customer already owns a perpetual license or is purchasing a perpetual license for UltiPro and is purchasing hosting services subsequently in a separate transaction whereas, with Intersourcing, the customer is purchasing the right to use (not license) UltiPro. Implementation services provided for Base Hosting arrangements are substantially less than those provided for Intersourcing arrangements since UltiPro is already implemented in Base Hosting arrangements and only needs to be transitioned to a hosted environment. Fair value for hosting services is based on the Hosting Valuation. Fair value for implementation services is assigned in accordance with guidelines provided by SOP 97-2 based on the Implementation Valuation. Services, including Implementation and Training Services Services revenues include revenues from fees charged for the implementation of the Company's software products and training of customers in the use of such products, fees for services provided to BSPs, including those related to the Ceridian Services Agreements through December 31, 2004, the provision of payroll- related forms and the printing of Form W-2's for certain customers, as well as certain reimbursable out-of- pocket expenses. Revenues for training and implementation consulting services are recognized as services are performed. Other services are recognized as the product is shipped or as the services are rendered depending on the speciÑc terms of the arrangement. Arrangement fees related to Ñxed-fee implementation services contracts are recognized using the percentage of completion accounting method, which involves the use of estimates. Percentage of completion is measured at each reporting date based on hours incurred to date compared to total estimated hours to complete. If a suÇcient basis to measure the progress towards completion does not exist, revenue is recognized when the project is completed or when the Company receives Ñnal acceptance from the customer. Recurring Revenues Recurring revenues include maintenance revenues and subscription revenues. Maintenance revenues are derived from maintaining, supporting and providing periodic updates for the Company's software. Subscription revenues are principally derived from PEPM fees earned through the Intersourcing OÅering, Base Hosting and the business service provider (BSP) sales channel (deÑned below), as well as revenues generated from the Original Ceridian Agreement (deÑned below). Maintenance revenues are recognized ratably over the service period, generally one year. Maintenance and support fees are generally priced as a percentage of the initial license fee for the underlying products. To the extent there are upfront fees associated with the Intersourcing OÅering, Base Hosting or the BSP sales channel, subscription revenues are recognized ratably over the term of the related contract upon the delivery of the product and services. PEPM fees from the Intersourcing OÅering, Base Hosting and the BSP sales channel are recognized as subscription revenue as the services are delivered. Commencing on August 28, 2002, subscription revenues generated from the Original Ceridian Agreement are recognized ratably over the minimum term of the contract, which is expected to extend until March 9, 2008 (7 years after the eÅective date of the Original Ceridian Agreement). Subscription revenues of approximately $642,000 per month are based on guaranteed minimum payments from Ceridian Corporation of approximately $42.7 million over the contract term, including $23.0 million received to date. Maintenance services provided to customers include product updates and technical support services. Product updates are included in general releases to the Company's customers and are distributed on a periodic basis. Such updates may include, but are not limited to, product enhancements, payroll tax updates, additional security features or bug Ñxes. All features provided in general releases are unspeciÑed upgrade rights. To the extent speciÑed upgrade rights or entitlements to future products are included in a multi-element arrange- ment; revenue is recognized upon delivery provided fair value for the elements exists. In multi-element arrangements that include a speciÑed upgrade right or entitlement to a future product, if fair value does not exist for all undelivered elements, revenue for the entire arrangement is deferred until all elements are delivered or when fair value can be established. 43 Subscription revenues generated from the BSP sales channel include both the right to use UltiPro and maintenance. The BSP is charged a fee on a PEPM basis and, in several cases, is subject to a guaranteed monthly minimum amount for the term of the related agreement. Revenue is recognized on a PEPM basis. To the extent the BSP pays the Company a one-time upfront fee, the Company accounts for such fee by recognizing it as subscription revenue over the minimum term of the related agreement. The Company recognizes revenue in accordance with the Securities Exchange Commission (""SEC'') StaÅ Accounting Bulletin No. 101, ""Revenue Recognition in Financial Statements'' (""SAB No. 101'') and the SEC StaÅ Accounting Bulleting No. 104, ""Revenue Recognition'' (""SAB No. 104''). Management believes the Company is currently in compliance with the current provisions set forth in SOP 97-2, SOP 98-9, EITF 00-21, EITF 00-3, SAB No. 101 and SAB No. 104. Concentration of Revenues During the years ended December 31, 2004 and 2003, Ceridian accounted for 15.5% and 16.6%, respectively, of total revenues. Ceridian did not account for more than 10% of total revenues in 2002. No other customer accounted for more than 10% of total revenues in the periods presented. Due to the signiÑcant concentration of total revenues with this single customer, the Company has exposure if this customer loses its credit worthiness. See Note 3. The composition of the revenues recognized from Ceridian, as a percentage of total revenues, for the years ended December 31, 2004, 2003 and 2002 was as follows: Recurring revenues Services revenues Total revenues 2004 2003 2002 10.9% 4.6 12.8% 3.8 15.5% 16.6% 4.8% Ì 4.8% Deferred Revenue Deferred revenue is primarily comprised of deferrals for recurring revenues for which maintenance services have not yet been rendered, implementation consulting services for which the services have not yet been rendered, Intersourcing services which are recognized over the term of the related contract as the services are performed, typically two years, and subscription revenues which are recognized ratably over the term of the related contract upon the delivery of the product and services. Cost of Revenues Cost of revenues consists of cost of license, recurring and services revenues. Cost of license revenues primarily consists of fees payable to a third-party for software products distributed by the Company and, to a lesser degree, amortization of capitalized software. Cost of recurring revenues consists of costs to provide maintenance and technical support to the Company's customers, the cost of providing periodic updates and the costs of subscription revenues, including amortization of capitalized software. Cost of service revenues primarily consists of costs to provide implementation services and training to the Company's customers, and, to a lesser degree, costs related to sales of payroll-related forms and costs associated with reimbursable out-of- pocket expenses. Income Taxes The Company is subject to corporate Federal and state income taxes and accounts for income taxes under the provisions of Statement of Financial Accounting Standards (""SFAS'') No. 109, ""Accounting for Income Taxes.'' SFAS No. 109 provides for a liability approach under which deferred income taxes are provided based upon enacted tax laws and rates applicable to the periods in which the taxes become payable. 44 Software Development Costs SFAS No. 86, ""Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed,'' requires capitalization of certain software development costs subsequent to the establishment of technological feasibility. Based on the Company's product development process, technological feasibility is established upon completion of a working model. There were no software costs capitalized during 2004, 2003 or 2002. Annual amortization is based on the greater of the amount computed using (a) the ratio that current gross revenues for the related product bears to the total of current and anticipated future gross revenues for that product or (b) the straight-line method over the remaining estimated economic life of the product including the period being reported on. Capitalized software is amortized using the straight-line method over the estimated useful lives of the assets, which are typically three years. Amortization of capitalized software was $1,151,000, $1,519,000 and $1,792,000 in 2004, 2003 and 2002, respectively. Accumulated amortization of capitalized software was $5.5 million and $4.4 million as of December 31, 2004 and 2003, respectively. Capitalized software, net of amortization, was $0.1 million and $1.2 million as of December 31, 2004 and 2003, respectively. The Company evaluates the recoverability of capitalized software based on estimated future gross revenues reduced by the estimated costs of completing the products and of performing maintenance and customer support. If the Company's gross revenues were to be signiÑcantly less than its estimates, the net realizable value of the Company's capitalized software intended for sale would be impaired, which could result in the write-oÅ of all or a portion of the unamortized balance of such capitalized software. Use of Estimates The preparation of Ñnancial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that aÅect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the Ñnancial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could diÅer from those estimates. Fair Value of Financial Instruments The Company's Ñnancial instruments, consisting of cash and cash equivalents, investments in marketable securities, accounts receivable, accounts payable, long-term debt and capital lease obligations approximated fair value as of December 31, 2004 and 2003. Accounting for Stock-Based Compensation As permitted by SFAS No. 123, ""Accounting for Stock-Based Compensation,'' the Company continues to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, ""Accounting for Stock Issued to Employees'' and has made the pro forma disclosures required by SFAS No. 123 for each of the three years in the period ended December 31, 2004. See Note 12. SFAS No. 123 requires pro forma information for options issued to employees and has been determined as if the Company had accounted for its stock-based compensation plan under the fair value method. The fair value of each option granted was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants: risk-free interest rates of 3.5% for 2004, 3.1% for 2003 and 2.7% for 2002, a dividend yield of 0% for all three years presented, expected volatility of 46% for 45 2004, 48% for 2003 and 68% for 2002 and an expected life of four years for 2004 and 2003 and three years for 2002. The Company's pro forma information is as follows (in thousands, except per share amounts): For the Years Ended December 31, 2002 2003 2004 Net loss: As reported ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Compensation expense, pro forma ÏÏÏÏÏÏÏÏ $(5,024) (1,997) $ (9,169) (1,424) $(14,568) (2,393) Pro formaÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $(7,021) $(10,593) $(16,961) Loss Per Share: As reported ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Compensation expense, pro forma ÏÏÏÏÏÏÏÏ $ (0.23) (0.09) $ (0.49) (0.08) $ (0.90) (0.15) Pro formaÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ (0.32) $ (0.57) $ (1.05) The weighted average grant date fair value per share of options granted during 2004, 2003 and 2002 were $5.02, $2.22 and $2.16, respectively. Earnings Per Share SFAS No. 128, ""Earnings Per Share,'' requires dual presentation of earnings per share Ì ""basic'' and ""diluted.'' Basic earnings per share is computed by dividing income available to common stockholders (the numerator) by the weighted average number of common shares (the denominator) for the period. The computation of diluted earnings per share is similar to basic earnings per share, except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potentially dilutive common shares had been issued. The following is a reconciliation of the shares used in the computation of basic and diluted net loss per share (in thousands): For the Years Ended December 31, 2003 2004 2002 Weighted average shares outstanding ÏÏÏÏÏÏÏÏÏ EÅect of dilutive stock options ÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 21,743 Ì Dilutive shares outstanding ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 21,743 18,738 Ì 18,738 16,189 Ì 16,189 Other common stock equivalents (i.e., stock options and warrants) not included in the computation of diluted net loss per share, as their impact is antidilutive, totaled 5,935,000, 5,797,000 and 4,821,000 for 2004, 2003 and 2002, respectively. Comprehensive Income (Loss) In 1998, the Company adopted SFAS No. 130, ""Reporting Comprehensive Income,'' which establishes standards for the reporting and display of comprehensive income and its components in a full set of Ñnancial statements. The objective of SFAS No. 130 is to report a measure (comprehensive income (loss)) of all changes in equity of an enterprise that result from transactions and other economic events in a period other than transactions with owners. Accumulated other comprehensive loss, as presented on the accompanying consolidated balance sheets and statements of stockholders' equity, consists entirely of unrealized gains on available-for-sale securities. Stock-Based Compensation The Company adopted SFAS No. 148, ""Accounting for Stock-Based CompensationÌTransition and DisclosureÌAn Amendment of SFAS No. 123'' (""SFAS No. 148'') in December 2002. SFAS No. 148 46 amends SFAS No. 123, ""Accounting for Stock-Based Compensation'' (""SFAS No. 123''), to provide alternative methods of transition for a voluntary change to the fair-value-based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in not only annual, but also interim Ñnancial statements about the eÅect the fair value method would have had on reported results. The Company accounted for stock-based compensation in accordance with SFAS No. 148. Guarantees The Company adopted FASB Interpretation No. 45, ""Guarantor's Accounting and Disclosure Require- ments for Guarantees, Including Indirect Guarantees of Indebtedness of Others,'' (""FIN 45'') on January 1, 2003. The provision for initial recognition and measurement of liability is applied on a prospective basis to guarantees issued or modiÑed after December 31, 2002. FIN 45 expands previously issued accounting guidance and disclosure requirements for certain guarantees and requires recognition of an initial liability for the fair value of an obligation assumed by issuing a guarantee. As an element of standard commercial terms in its standard sales contracts for UltiPro, the Company includes an indemniÑcation clause that indemniÑes the customer against certain liabilities and damages arising from any claims of patent, copyright, or other proprietary rights of any third party. Due to the nature of the intellectual property indemniÑcation provided to its customers, the Company can not estimate the fair value, nor determine the total nominal amount, of the indemniÑcation until such time as a claim for such indemniÑcation is made. In the event of a claim made against the Company under such provision, the Company evaluates estimated losses for such indemniÑcation under SFAS No. 5, ""Accounting for Contingencies,'' as interpreted by FIN 45, considering such factors as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, the Company has not had any claims made against it under such provision and, accordingly, has not accrued any liabilities related to such indemniÑcations in its unaudited condensed consolidated Ñnancial statements. Segment Information The Company adopted SFAS No. 131, ""Disclosures about Segments of an Enterprise and Related Information,'' eÅective December 31, 1998 (""SFAS No. 131''). SFAS No. 131 establishes standards for the way that public companies report selected information about operating segments in annual and interim Ñnancial reports to shareholders. It also establishes standards for related disclosures about an enterprise's business segments, products, services, geographic areas and major customers. The Company operates its business as a single segment. Reimbursable Out-Of-Pocket Expenses EÅective January 1, 2002, the Company adopted Financial Accounting Standards Board Emerging Issues Task Force No. 01-14, ""Income Statement Characterization of Reimbursements Received for "Out-of- Pocket' Expenses Incurred'' (""EITF 01-14''). EITF 01-14 requires companies to characterize reimburse- ments received for out-of-pocket expenses incurred as revenue and to reclassify prior period Ñnancial statements to conform to current year presentation for comparative purposes. Reimbursable out-of-pocket expenses, which are included in services revenues and cost of services revenues in the Company's accompany- ing consolidated statements of operations, were $1.0 million, $1.3 million and $1.2 million for 2004, 2003 and 2002 respectively. Prior to the adoption of EITF 01-14, the Company's historical consolidated Ñnancial statements oÅset these amounts within cost of services revenues. Recent Accounting Literature In December 2004, the FASB issued SFAS No. 123 (revised 2004), ""Share-Based Payment'' (""SFAS 123R''), which replaces SFAS No. 123, ""Accounting for Stock-Based Compensation'' (""SFAS 123'') and supercedes APB Opinion No. 25, ""Accounting for Stock Issued to Employees.'' SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the Ñnancial statements based on their fair values and the recording of such expense in the 47 consolidated statements of operations. The accounting provisions of SFAS 123R are eÅective for reporting periods beginning after June 15, 2005. The Company is required to adopt the provisions of SFAS 123R eÅective July 1, 2005. The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to Ñnancial statement recognition. Under SFAS 123R, the Company must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. The Company has not yet determined the method of adoption or the eÅect of adopting SFAS 123R, and has not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS 123. In December 2003, the FASB issued a revised Interpretation No. 46, ""Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51,'' (""FIN 46R''). FIN 46R requires the consolidation of entities in which an enterprise absorbs a majority of the entity's expected losses, receives a majority of the entity's expected residual returns, or both, as a result of ownership, contractual or other Ñnancial interests in the entity. Currently entities are generally consolidated by an enterprise when it has a controlling Ñnancial interest through ownership of a majority voting interest in the entity. The provisions of FIN 46R are generally eÅective for existing (prior to February 1, 2003) variable interest relationships of a public entity no later than the end of the Ñrst reporting period that ends after March 15, 2004. However, prior to the required application of this interpretation a public entity that is not a small business issuer shall apply FIN 46R to those entities that are considered to be special-purpose entities no later than the end of the Ñrst reporting period that ends after December 15, 2003. The adoption of FIN 46R did not have an impact on the Company's consolidated Ñnancial statements. 3. SIGNIFICANT TRANSACTIONS Original Ceridian Agreement During 2001, Ultimate Software and Ceridian Corporation (""Ceridian'') reached an agreement, as amended in 2002, which granted Ceridian a non-exclusive license to use UltiPro software as part of an on-line oÅering that Ceridian can market primarily to businesses with under 500 employees (the ""Original Ceridian Agreement''). Ceridian marketed that solution under the name SourceWeb. Under the agreement, Ceridian is responsible for all marketing costs and expenses, and must sell the licensed software on a per period, per employee, per paycheck basis or other repetitive payment model. Ceridian is required to pay the Company a monthly license fee based on the number of employees paid using the licensed software. These payments are subject to a minimum monthly payment of $500,000 per month with increases of 5% per annum, compounded beginning in January 2006. The maximum monthly payment is $1.0 million, subject to increases of 5% per annum, compounded. The aggregate minimum payments that Ceridian is obligated to pay Ultimate Software under the Original Ceridian Agreement over the minimum term of the agreement is $42.7 million. To date, Ceridian has paid to Ultimate Software a total of $23.0 million under the Original Ceridian Agreement. The earliest date upon which the Ceridian Agreement can be terminated by either party (except for an uncured material breach) is March 9, 2008, resulting in an expected minimum term of 7 years. Ceridian retains certain rights to use the software upon termination. During December 2004, RSM McGladrey Employer Services, an existing business service provider of Ultimate Software's, acquired Ceridian's SourceWeb HR/payroll and self-service product and existing SourceWeb base of small and midsize business customers throughout the United States (the ""RSM Acquisition''). The Ñnancial terms of the Original Ceridian Agreement have not changed as a result of the RSM Acquisition. Ceridian will continue to be Ñnancially obligated to pay Ultimate Software a minimum fee of $500,000 per month with increases of 5% per annum, compounded beginning in January 2006. Ultimate Software expects to continue to recognize a minimum of $642,000 per month in recurring subscription revenues from the Original Ceridian Agreement until its termination. Ceridian Services Agreements On April 7, 2004, the Company and Ceridian extended their services agreement which expired on December 31, 2003 (the ""Extended Ceridian Services Agreement''). Under the Extended Ceridian Services 48 Agreement, which was eÅective January 1, 2004 through September 30, 2004, Ceridian was obligated to pay Ultimate Software a total of $2.5 million in three equal installments in exchange for services provided by Ultimate Software during the term of that agreement. All three installment payments due under the Extended Services Agreement were received by the Company through July 2004. During October 2004, the Extended Ceridian Services Agreement was further extended until December 31, 2004 for a fee of $0.8 million, received in a single installment in November 2004. Services revenue from the Extended Ceridian Services Agreement was recognized on a straight-line basis from January 1, 2004 through December 31, 2004. The Extended Ceridian Services Agreement expired on December 31, 2004 and was not renewed. 4. INVESTMENTS IN MARKETABLE SECURITIES Investments in marketable securities consist entirely of equity securities available-for-sale. Included in accumulated other comprehensive loss for 2004 is $15,558 of unrealized loss on trading securities held at year end. There was no unrealized gain or loss in 2003 and 2002 as no such securities were held during those periods. 5. ACQUISITION On June 9, 2003, the Company purchased substantially all of the assets of HireWorks, Inc., a software company that developed, marketed and supported an Internet recruitment solution. The assets acquired included customer contracts, the source code for its software and computer equipment. The Company has accounted for this transaction as a purchase. The resulting intangible asset related to the customer contracts acquired is being amortized over 26 months. The Company had no acquisitions in 2004. 6. STOCK REPURCHASE PLAN On October 30, 2000, the Company announced that its board of directors authorized the repurchase of up to 1,000,000 shares of the Company's outstanding Common Stock (the ""Stock Repurchase Plan''). Stock repurchases may be made periodically in the open market, in privately negotiated transactions or a combination of both. The extent and timing of these transactions will depend on market conditions and other business considerations. There were no repurchases of the Company's Common Stock during 2004 and 2003. During 2002, the Company purchased 46,150 shares of the Company's Common Stock under the Stock Repurchase Plan at an average cost of $4.14 per share. As of December 31, 2004 and 2003, the Company had purchased 257,647 shares of the Company's Common Stock under the Stock Repurchase Plan. 7. ACCRUED EXPENSES Accrued expenses consist of the following (in thousands): Sales commissions ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Other items individually less than 5% of total current As of December 31, 2003 2004 $1,258 $1,246 liabilities ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 4,757 4,132 $6,015 $5,378 49 8. PROPERTY AND EQUIPMENT Property and equipment consists of the following (in thousands): As of December 31, 2003 2004 Computer equipment ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Leasehold improvements ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Furniture and Ñxtures ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ BuildingÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Land ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 21,073 4,038 1,306 670 655 $ 16,473 3,952 1,281 Ì Ì Less accumulated depreciation and amortization ÏÏÏÏ 27,742 (18,230) 21,706 (14,518) $ 9,512 $ 7,188 Included in property and equipment is equipment acquired under capital leases as follows (in thousands): Equipment ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Less accumulated amortization ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 7,543 (6,057) $ 6,161 (4,941) $ 1,486 $ 1,220 As of December 31, 2003 2004 Depreciation and amortization expense on property and equipment totaled $3,754,000, $3,424,000 and $3,823,000, for the years ended December 31, 2004, 2003 and 2002, respectively. 9. CAPITAL LEASE OBLIGATIONS The Company leases certain equipment under noncancellable agreements, which are accounted for as capital leases and expire at various dates through 2007. Interest rates on these leases range from 1.0% to 10.0%. The annual maturities of the capital lease obligations are as follows as of December 31, 2004 (in thousands): Year 2005 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 2006 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 2007 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Less amount representing interestÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Amount $ 990 824 153 1,967 (87) Lease obligations reÖected as current ($928) and non-current ($952) ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $1,880 10. REVOLVING CREDIT FACILITY AND LONG-TERM DEBT In November 2001, the Company entered into a $5.0 million revolving line of credit (the ""Credit Facility'') with Silicon Valley Bank. The Credit Facility, as amended, expires on May 27, 2005 and bears interest at a rate equal to Prime Rate plus 1.0% per annum (reduced to Prime Rate plus 0.5% per annum upon two consecutive quarters of net proÑtability, as deÑned). The Credit Facility provides working capital Ñnancing for up to 75% of the Company's eligible accounts receivable not to exceed $3.0 million (the ""Revolving Note''), as deÑned, stand-by letters of credit for up to $0.5 million as a component of the Revolving Note and Ñnancing for eligible equipment purchases for up to $2.0 million with additional limits for software purchases (the ""Equipment Term Note''). The Equipment Term Note is payable in 36 equal 50 monthly installments, plus interest at Prime Rate plus 1%. The maximum amount available under the Credit Facility is $5.0 million. At December 31, 2004, $4.5 million was available for borrowing under the Credit Facility with $0.4 million outstanding under the Equipment Term Note. Borrowings under the Credit Facility are secured by all of the Company's corporate assets, including a negative pledge on intellectual property, and the Company is required to comply with certain Ñnancial and other covenants. Under the terms of the Credit Facility, the Company may not pay dividends without the prior written consent of Silicon Valley Bank. The material covenants require that the Company maintain, on a monthly basis, a minimum quick ratio (representing the ratio of current assets to current liabilities, excluding deferred revenue) of 1.75 to 1.0 and certain quarterly revenue levels as of the end of each quarter, as provided in the Credit Facility, as amended. As of December 31, 2004, the Company was in compliance with all covenants included in the terms of the Credit Facility. 11. INCOME TAXES No provision or beneÑt for Federal or state income taxes was made for 2004, 2003 and 2002 due to the operating losses incurred in the respective periods. The provision for income taxes is diÅerent from that which would be obtained by applying the statutory Federal income tax rate of 35% to loss before income taxes as a result of the following (in thousands): For the Year Ended December 31, 2002 2003 2004 Income tax beneÑt at statutory Federal tax rate ÏÏÏÏÏÏÏ State and local income taxes ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Non deductible expenses ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Change in valuation allowance ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Other, netÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $(1,758) (289) 320 1,752 (25) $(3,210) (527) 248 3,514 (25) $(5,099) (838) 210 5,768 (41) Provision for income taxes ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ Ì $ Ì $ Ì The components of the net deferred tax assets included in the accompanying consolidated balance sheets are as follows (in thousands): As of December 31, 2003 2004 2002 Deferred tax assets: Net operating losses ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Deferred revenueÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Depreciation and amortizationÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Accruals not currently deductible ÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Allowance for doubtful accounts ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Other, netÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 25,640 4,467 1,102 85 204 3 $ 23,092 4,160 904 227 214 3 $ 17,851 6,264 835 177 408 3 Gross deferred tax assets ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Less valuation allowance ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 31,501 (31,177) 28,600 (27,959) 25,538 (24,233) Net deferred tax assetsÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 324 641 1,305 Deferred tax liabilities: Software development costs ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Prepaid commissionsÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Gross deferred tax liabilities ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ (34) (290) (324) (502) (139) (641) (1,121) (184) (1,305) Net deferred taxes ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ Ì $ Ì $ Ì 51 The Company has provided a full valuation allowance on the deferred tax assets as realization of such amounts is not considered more likely than not. The Company reviews the valuation allowance requirement periodically and makes adjustments as warranted. Of the total valuation allowance at December 31, 2004, approximately $2,180,000 is attributed to net operating losses generated from the exercise of non-statutory employee stock options, the beneÑt of which will be credited to additional paid-in capital when realized. Of the change in the valuation allowance for 2004, 2003 and 2002, approximately $1,466,000, $212,000 and $4,000, respectively, is attributable to exercise of non-statutory employee stock options. At December 31, 2004, the Company had approximately $62,900,000 of net operating loss carryforwards for Federal income tax reporting purposes available to oÅset future taxable income. Of the total net operating loss carryforwards, approximately $5,350,000 is attributable to deductions from the exercise of non-statutory employee stock options. The carryforwards expire through 2024. Utilization of such net operating losses may be limited as a result of cumulative ownership changes in the Company's equity instruments. 12. STOCKHOLDERS' EQUITY Private Sales of Common Stock On May 12, 2004, the Company entered into a deÑnitive agreement to sell 1,398,182 newly issued shares of the Company's common stock, par value $0.01 per share (the ""Common Stock'') to three institutional investors in a private placement for gross proceeds of approximately $15.4 million (the ""Recent Capital Raised''). These shares of Common Stock were sold at $11.00 per share. After deducting commissions and other stock issuance costs, the Company received approximately $14.4 million. The Company is using the net proceeds from the Recent Capital Raised for general corporate purposes, including working capital and funding the Company's transition from a license model to a business model with a higher percentage of recurring revenues. The Company Ñled a registration statement with the Securities and Exchange Commis- sion on Form S-3 (Registration No. 333-115894) covering resales of the Common Stock by investors, which registration statement was declared eÅective on June 25, 2004. From January 1, 2003 through July 16, 2003, the Company raised an aggregate of approximately $17.5 million of capital, net of estimated stock issuance costs, through the private sales of (i) a total of 1,708,000 shares of the Common Stock, and warrants to purchase an aggregate 170,800 shares of Common Stock at $4.00 per share to investors, including Ceridian Corporation and some existing shareholders; and (ii) a total of 2,200,000 shares of Common Stock at $5.30 per share, before stock issuance costs, to two institutional investors. Stock-Based Compensation The Company has adopted The Ultimate Software Group, Inc. NonqualiÑed Stock Option Plan (the ""Plan'') under which the Company is authorized to issue options to purchase a total of 9,000,000 shares of the Company's Common Stock to directors, oÇcers and employees of the Company. Under the Plan, options to purchase shares of Common Stock may be granted at prices equal to the fair market value of shares of the Company's Common Stock as of the date of grant, or at such other amount as may be determined by the Compensation Committee of the Board of Directors appointed to administer the Plan (the ""Committee''). The Committee has discretion under the Plan to prescribe vesting periods for options which are granted under the Plan. In addition, options granted under the Plan become immediately exercisable in the event of a change in control of the Company and in certain other circumstances. The maximum term of the options granted under the Plan is 10 years. As of December 31, 2004, options to purchase 2,405,525 shares of the Company's Common Stock were available for grant under the Plan. The Plan provides that non-employee members of the Company's Board of Directors shall receive options in lieu of any retainer or meeting fees for serving on the Board or committees thereof. Such options vest upon the date of grant and have an exercise price equal to 30% of fair market value of the Company's Common Stock on the date of the grant. Options granted to non-employee Board members prior to December 31, 2004 are fully exercisable upon grant date. 52 A summary of stock options under the Company's Plan as of December 31, 2004, 2003 and 2002, and changes during the years then ended, is presented below: Outstanding at December 31, 2001 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Granted ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Exercised ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Canceled ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Outstanding at December 31, 2002 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Granted ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Exercised ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Canceled ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Outstanding at December 31, 2003 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Granted ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Exercised ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Canceled ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Shares 4,596,241 345,769 (7,275) (205,461) 4,729,274 1,018,814 (135,495) (56,445) 5,556,148 674,756 (478,446) (14,153) Outstanding at December 31, 2004 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 5,738,305 Weighted Average Exercise Price $ 6.06 3.54 3.92 6.58 $ 5.84 5.93 3.86 5.43 $ 5.89 12.04 4.55 8.49 $ 6.70 The following table summarizes information about stock options outstanding under the Plan at December 31, 2004: Range of Exercise Prices Contractual Life Weighted-Average Number (Years) Exercise Price Number Weighted-Average Exercise Price Options Outstanding Weighted-Average Remaining Options Exercisable $0.89Ì$3.38 ÏÏÏÏÏÏÏÏ $3.38Ì$4.23 ÏÏÏÏÏÏÏÏ $4.25Ì$5.16 ÏÏÏÏÏÏÏÏ $6.24Ì$7.00 ÏÏÏÏÏÏÏÏ $7.21Ì$7.21 ÏÏÏÏÏÏÏÏ $7.63Ì$7.63 ÏÏÏÏÏÏÏÏ $7.75Ì$9.40 ÏÏÏÏÏÏÏÏ $10.00Ì$11.53 ÏÏÏÏÏÏ $11.76Ì$11.76 ÏÏÏÏÏÏ $13.05Ì$13.05 ÏÏÏÏÏÏ 961,575 724,398 787,261 98,387 826,842 573,844 803,654 585,894 13,450 363,000 $0.89Ì$13.05 ÏÏÏÏÏÏÏ 5,738,305 6.39 7.78 3.65 4.87 2.82 4.80 6.49 6.43 9.30 9.80 5.73 $ 2.81 3.88 4.97 6.57 7.21 7.63 8.60 10.61 11.76 13.05 $ 6.70 954,325 391,384 787,261 85,387 826,842 573,844 633,776 383,512 3,366 90,938 4,730,635 $ 2.80 3.85 4.97 6.62 7.21 7.63 8.41 10.24 11.76 13.05 $ 6.23 53 A summary of warrants to purchase shares of the Company's Common Stock as of December 31, 2004, 2003 and 2002, and changes during the years then ended, is presented below: Outstanding at December 31, 2001ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ GrantedÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Exercised ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ CanceledÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Outstanding at December 31, 2002ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ GrantedÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Exercised ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ CanceledÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Outstanding at December 31, 2003ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ GrantedÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Exercised ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ CanceledÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Shares Ì 67,500 Ì Ì 67,500 170,800 (12,500) Ì 225,800 Ì (28,750) Ì Outstanding at December 31, 2004ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 197,050 Weighted Average Exercise Price $ Ì 4.00 4.00 4.00 $4.00 4.00 4.00 4.00 $4.00 4.00 4.00 4.00 $4.00 Common Stock The holders of Common Stock are entitled to one vote per share for each share held of record on all matters submitted to a vote of the stockholders. Other Equity Transactions The following table summarizes information about stock options granted by the Company to non- employee directors to purchase the Company's Common Stock in exchange for services rendered for 2004, 2003 and 2002 (""Board Options''): Exercise Price of Stock Options Granted(1)(2)(3) Number of Options Granted 2002: 2003: 2004: $1.23 1.32 0.96 0.89 3.10 1.19 1.58 2.58 2.67 4.05 3.17 3.87 3.65 7,315 8,766 7,614 12,528 100,000 10,850 7,892 4,818 7,067 3,074 3,926 4,146 4,806 (1) In 2002, options to purchase 100,000 shares of the Company's Common Stock for $3.10 per share were granted at fair market value to non-employee directors. All other stock option grants to non-employee 54 directors during 2004, 2003 and 2002 were granted at an exercise price equal to 30% of the fair market value of the Company's Common Stock on the date of grant. (2) Such options are currently exercisable and were valued on the date of grant in accordance with the requirements prescribed in APB 25. See Note 2. These options were granted in lieu of cash retainers and meeting fees. (3) The compensation expense related to the Board Options granted in 2004, 2003 and 2002, determined pursuant to the application of APB 25, was $136,000, $132,000 and $86,000, respectively, and is included in general and administrative expenses in the accompanying consolidated statements of operations. 13. COMMITMENTS AND CONTINGENCIES Operating Leases The Company leases corporate oÇce space and certain equipment under noncancellable operating lease agreements expiring at various dates. Total rent expense under these agreements was $2,659,000, $2,408,000 and $2,024,000 for the years ended December 31, 2004, 2003 and 2002, respectively. Future minimum annual rental commitments related to these leases are as follows at December 31, 2004 (in thousands): Year 2005 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 2006 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 2007 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 2008 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 2009 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Thereafter ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Amount $ 1,775 1,653 1,555 1,520 1,448 9,216 $17,167 Product Liability Software products such as those oÅered by the Company frequently contain undetected errors or failures when Ñrst introduced or as new versions are released. Testing of the Company's products is particularly challenging because it is diÇcult to simulate the wide variety of computing environments in which the Company's customers may deploy these products. Despite extensive testing, the Company from time to time has discovered defects or errors in products. There can be no assurance that such defects, errors or diÇculties will not cause delays in product introductions and shipments, result in increased costs and diversion of development resources, require design modiÑcations or decrease market acceptance or customer satisfaction with the Company's products. In addition, there can be no assurance that, despite testing by the Company and by current and potential customers, errors will not be found after commencement of commercial shipments, resulting in loss of or delay in market acceptance, which could have a material adverse eÅect upon the Company's business, operating results and Ñnancial condition. Litigation From time-to-time, the Company is involved in litigation relating to claims arising out of its operations in the normal course of business. The Company is not currently a party to any legal proceeding the adverse outcome of which, individually or in the aggregate, could reasonably be expected to have a material adverse eÅect on the Company's operating results or Ñnancial condition. 14. RELATED PARTY TRANSACTIONS During the fourth quarter of 2001, The Company began leasing equipment with a computer leasing company (the ""Leasing Company'') that is owned by an irrevocable trust (the ""Trust'') for the beneÑt of the children of Robert A. Yanover, a member of the Company's Board of Directors. Additionally, the Leasing Company's business is managed and operated by a management company (the ""Management Company'') 55 pursuant to a management agreement. Mr. Yanover has a 50% ownership interest in the general partner of the Management Company. The Company did not Ñnance equipment with the Leasing Company in 2004 or 2003. The Company Ñnanced equipment with the Leasing Company totaling $1,007,000 and $258,000 during 2002 and 2001, respectively. Related amortization was $331,000, $506,000 and $415,000 and total cash paid was $499,000, $569,000 and $467,000 during 2004, 2003 and 2002, respectively. The unamortized capital lease obligation with the Leasing Company and related accumulated amortization were $0 and $1,265,000, respectively, at December 31, 2004, $360,000 and $933,000, respectively, at December 31, 2003 and $869,000 and $427,000, respectively, at December 31, 2002. The Company believes that the terms of the leases were no less favorable to the Company than could have been obtained from an unaÇliated party. 15. EMPLOYEE BENEFIT PLAN The Company provides retirement beneÑts for eligible employees, as deÑned, through a deÑned contribution beneÑt plan that is qualiÑed under Section 401(k) of the Internal Revenue Code (the ""Plan''). Contributions to the Plan, which are made at the sole discretion of the Company, were $718,000, $587,000 and $602,000 for the years ended December 31, 2004, 2003 and 2002, respectively. Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure None. Item 9A. Controls and Procedures Evaluation of Disclosure Controls and Procedures The Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Chief Executive OÇcer (the ""CEO'') and the Chief Financial OÇcer (the ""CFO''), of the eÅectiveness of the design and operation of the Company's disclosure controls and procedures as of the end of the period covered by this report pursuant to Securities Exchange Act of 1934 Rule 13a-15. Based on that evaluation, the Company's management, including the CEO and CFO, concluded that the Company's disclosure controls and procedures are eÅective in timely alerting them to material information required to be included in the Company's periodic SEC reports. It should be noted that the design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote. Management's Annual Report on Internal Control Over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over Ñnancial reporting, as such term is deÑned in Exchange Act Rules 13a-15(f). Under the supervision and with the participation of our management, including our principal executive oÇcer and principal Ñnancial oÇcer, we conducted an evaluation of the eÅectiveness of our internal control over Ñnancial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control-Integrated Framework, our management concluded that our internal control over Ñnancial reporting was eÅective as of December 31, 2004. Our management's assessment of the eÅectiveness of our internal control over Ñnancial reporting as of December 31, 2004 has been audited by KPMG LLP, an independent registered public accounting Ñrm, as stated in their report, which is included below. Report of Independent Registered Public Accounting Firm The Board of Directors and Stockholders The Ultimate Software Group, Inc.: We have audited management's assessment, included in the accompanying Management's Annual Report on Internal Control Over Financial Reporting that The Ultimate Software Group, Inc. and subsidiary 56 (the ""Company'') maintained eÅective internal control over Ñnancial reporting as of December 31, 2004, based on criteria established in Internal Control Ó Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for maintaining eÅective internal control over Ñnancial reporting and for its assessment of the eÅectiveness of internal control over Ñnancial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the eÅectiveness of the Company's internal control over Ñnancial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether eÅective internal control over Ñnancial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over Ñnancial reporting, evaluating management's assessment, testing and evaluating the design and operating eÅectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over Ñnancial reporting is a process designed to provide reasonable assurance regarding the reliability of Ñnancial reporting and the preparation of Ñnancial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over Ñnancial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reÖect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of Ñnancial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material eÅect on the Ñnancial statements. Because of its inherent limitations, internal control over Ñnancial reporting may not prevent or detect misstatements. Also, projections of any evaluation of eÅectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management's assessment that the Company maintained eÅective internal control over Ñnancial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in Internal Control Ó Integrated Framework issued by the COSO. Also, in our opinion, the Company maintained, in all material respects, eÅective internal control over Ñnancial reporting as of December 31, 2004, based on criteria established in Internal Control Ó Integrated Framework issued by the COSO. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of the Company as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders' equity (deÑcit), and cash Öows for each of the years in the three-year period ended December 31, 2004, and our report dated March 10, 2005 expressed an unqualiÑed opinion on those consolidated Ñnancial statements. Miami, Florida March 10, 2005 /s/ KPMG LLP KPMG LLP 57 Changes in Internal Control over Financial Reporting There have been no signiÑcant changes in internal control over Ñnancial reporting during the fourth quarter of 2004 that have materially aÅected, or are reasonably likely to materially aÅect, the Company's internal control over Ñnancial reporting. Item 9B. Other Information On October 20, 2004, the Compensation Committee of the Board of Directors approved awards under the Company's NonqualiÑed Stock Option Plan to employees of the Company, including executive oÇcers. The options granted have an exercise price equal to the fair market value of the Common Stock as of the close of business on the date of grant ($13.05) and vest as follows: 25% of the options were immediately vested, an additional 25% shall become vested at each of the Ñrst, second and third anniversaries of the grant, provided in each case that the individual is employed by the Company on such date. The number of shares subject to the options granted to the executive oÇcers were as follows: Scott Scherr, 100,000; Marc D. Scherr, 75,000; and Mitchell K. Dauerman, 25,000. 58 PART III Item 10. Directors and Executive OÇcers of the Registrant The directors, executive oÇcers (Messrs. Scott Scherr, Marc D. Scherr and Mitchell K. Dauerman) and other key employees of the Company, and their ages as of February 18, 2005, are as follows: Name Age Position(s) Scott Scherr ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 52 Marc D. ScherrÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 47 Mitchell K. Dauerman ÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 47 Jon Harris ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Robert Manne ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Vivian Maza ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Linda Miller ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Laura JohnsonÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Adam Rogers ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Greg Swick ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Bill HicksÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Roy L. Gerber, Ph.D. ÏÏÏÏÏÏÏÏÏÏÏÏÏÏ James A. FitzPatrick, Jr. ÏÏÏÏÏÏÏÏÏÏÏ LeRoy A. Vander Putten ÏÏÏÏÏÏÏÏÏÏÏÏ Rick A. Wilber ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Robert A. Yanover ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 40 51 43 60 40 30 41 39 48 55 70 58 68 Chairman of the Board, President and Chief Executive OÇcer Vice Chairman of the Board and Chief Operating OÇcer Executive Vice President, Chief Financial OÇcer and Treasurer Senior Vice President, Services Senior Vice President, General Counsel Senior Vice President, People and Secretary Senior Vice President, Marketing Senior Vice President, Product Strategy Senior Vice President, Development Senior Vice President, Sales Vice President, Chief Information OÇcer Vice President, Chief Technology OÇcer Director Director Director Director Scott Scherr has served as President and a director of the Company since its inception in April 1996 and has been Chairman of the Board and Chief Executive OÇcer of the Company since September 1996. Mr. Scherr is also a member of the Executive Committee of the Board of Directors (the ""Board''). In 1990, Mr. Scherr founded The Ultimate Software Group, Ltd. (the ""Partnership''), the business and operations of which were assumed by the Company in 1998. Mr. Scherr served as President of the Partnership's general partner from the inception of the Partnership until its dissolution in March 1998. From 1979 until 1990, he held various positions at Automatic Data Processing, Inc. (""ADP''), a payroll services company, where his titles included Vice President of Operations and Sales Executive. Prior to joining ADP, Mr. Scherr operated Management Statistics, Inc., a data processing service bureau founded by his father, Reuben Scherr, in 1959. He is the brother of Marc Scherr, the Vice Chairman of the Board of the Company and the father-in-law of Adam Rogers, Senior Vice President, Development. Marc D. Scherr has been a director of the Company since its inception in April 1996 and has served as Vice Chairman since July 1998 and as Chief Operating OÇcer since October 2003. Mr. Scherr is also a member of the Executive Committee of the Board. Mr. Scherr became an executive oÇcer of the Company eÅective March 1, 2000. Mr. Scherr served as a director of Gerschel & Co., Inc., a private investment Ñrm from January 1992 until March 2000. In December 1995, Mr. Scherr co-founded Residential Company of America, Ltd. (""RCA''), a real estate Ñrm, and served as President of its general partnership until March 2000. Mr. Scherr also served as Vice President of RCA's general partnership from its inception in August 1993 until December 1995. From 1990 to 1992, Mr. Scherr was a real estate pension fund advisor at Aldrich, Eastman & Waltch. Previously, he was a partner in the Boston law Ñrm of Fine & Ambrogne. Mr. Scherr is the brother of Scott Scherr, Chairman of the Board, President and Chief Executive OÇcer of the Company. Mitchell K. Dauerman has served as Executive Vice President of the Company since April 1998 and as Chief Financial OÇcer and Treasurer of the Company since September 1996. From 1979 to 1996, 59 Mr. Dauerman held various positions with KPMG LLP, serving as a Partner in the Ñrm from 1988 to 1996. Mr. Dauerman is a CertiÑed Public Accountant. Jon Harris has served as Senior Vice President, Services since January 1, 2002. Mr. Harris served as Vice President, Professional Services from July 1998 through December 31, 2001. From 1992 to 1997, Mr. Harris held various management positions within ADP's National Accounts Division. From 1989 to 1992, Mr. Harris held the position of Consulting Services Director for Sykes Enterprises, Inc., a diverse information technology company. Robert Manne has served as Senior Vice President, General Counsel since February 2004 and as Vice President, General Counsel from May 1999 through January 2004. Prior to joining the Company, Mr. Manne was an attorney and partner of Becker & PoliakoÅ, P.A., an international law Ñrm, since 1978. In addition to administering the Litigation Department of the law Ñrm, Mr. Manne was a permanent member of the Ñrm's executive committee which was responsible for law Ñrm operations. Mr. Manne has performed legal services for the Company since its inception. Vivian Maza has served as Senior Vice President, People for the Company since February 2004 and as Vice President, People from January 1998 through January 2004. Ms. Maza has served as Secretary of the Company since September 1996. Prior to that, Ms. Maza served as the OÇce Manager of the Company from its organization in April 1996 and of the Partnership from its inception in 1990 until April 1996. Ms. Maza is a HR Generalist and holds a Professional in Human Resources (PHR) certiÑcation from the Society for Human Resource Management (SHRM) association. From 1985 to 1990, Ms. Maza was a systems analyst for the Wholesale Division of ADP. Linda Miller has served as Senior Vice President, Marketing since February 2004 and as Vice President, Communications and Public Relations from January 1999 through January 2004. Ms. Miller served as Vice President, Marketing, for the Company from July 1998 to January 1999. Prior to that, Ms. Miller served as the Company's Director of Marketing from January 1997. From 1992 to 1996, Ms. Miller held various positions at Best Software, Inc., a developer of corporate resource management applications, Abra Products Division, including Public Relations Manager. Laura Johnson has served as Senior Vice President, Product Strategy since February 2004 and as Vice President, Product Strategy from July 1998 through January 2004. From May 1996 to July 1998, Ms. Johnson served as the Director of Applications Consulting for the Company. From 1991 to 1996, Ms. Johnson held various positions with Best Software, Inc., Abra Products Division. Ms. Johnson holds a CertiÑed Payroll Professional (CPP) certiÑcation from the American Payroll Association (APA). Adam Rogers has served as Senior Vice President, Development since December 2002. From July 2001 to December 2002, Mr. Rogers served as Vice President of Engineering. From May 1997 to July 2001, Mr. Rogers held various positions in the Company's research and development organization, including Director of Technical Support from October 1998 to November 1999 and Director of Web Development from November 1999 to July 2001. Mr. Rogers is the son-in-law of Scott Scherr, Chairman of the Board, President and Chief Executive OÇcer of the Company. Greg Swick has served as Senior Vice President, Sales since January 2001. Mr. Swick served as Vice President and General Manager of the PEO Division of the Company's sales organization from November 1999 to January 2001. From February 1998 to November 1999, Mr. Swick was Director of Sales, Northeast Division. Prior to joining the Company, Mr. Swick was President of The Ultimate Software Group of New York and New England, G.P., a reseller of the Company which was acquired by the Company in March 1998. From 1987 to 1994, Mr. Swick held various positions with ADP, where the most recent position was Area Vice President Ì ADP Dealer Services Division. Bill Hicks has served as Vice President, Chief Information OÇcer since February 2004. From 1993 until February 2004, Mr. Hicks held various positions in the management of technologies for Precision Response Corporation, a wholly-owned subsidiary of Interactive Corporation and a provider of call centers and online commerce customer care services, including Chief Information OÇcer and Senior Vice President of Technology from August 2000 until February 2004. 60 Roy L. Gerber, Ph.D. has served as Vice President, Chief Technology OÇcer since January 1, 2002. Mr. Gerber served as Vice President, Engineering from October 1999 through December 31, 2001. From 1995 to October 1999, Mr. Gerber served in various positions in the research and development organization, including Director of Engineering. Prior to joining the Company, from 1988 to 1995, Mr. Gerber was Executive Vice President of Development for Cascade Interactive Designs, Inc. and dBSi which developed and marketed medical software products. From 1984 to 1988, Mr. Gerber was Executive Vice President and Chief Operating OÇcer of PaciÑc Retirement Plans, Inc. James A. FitzPatrick, Jr. has served as a director of the Company since July 2000. Mr. FitzPatrick is a partner in the law Ñrm Dewey Ballantine LLP, which provides legal services to the Company. Before joining Dewey Ballantine LLP as a partner in February 1989, Mr. FitzPatrick was a partner in the law Ñrm LeBoeuf, Lamb, Leiby & MacRae. LeRoy A. Vander Putten has served as a director of the Company since October 1997, is Chairman of the Compensation Committee of the Board and is a member of the Audit Committee of the Board. Mr. Vander Putten has served as the Executive Chairman of The Insurance Center, Inc., a holding company for 14 insurance agencies, since October 2001. Previously, he served as the Chairman of CORE Insurance Holdings, Inc., a member of the GE Global Insurance Group, engaged in the underwriting of casualty reinsurance, from August 2000 to August 2001. From April 1998 to August 2000, he served as Chairman of Trade Resources International Holdings, Ltd., a corporation engaged in trade Ñnance for exporters from developing countries. From January 1988 until May 1997, Mr. Vander Putten was Chairman and Chief Executive OÇcer of Executive Risk Inc., a specialty insurance holding company. From August 1982 to January 1988, Mr. Vander Putten served as Vice President and Deputy Treasurer of The Aetna Life and Casualty Company, an insurance company. Rick A. Wilber has served as a director of the Company since October 2002 and is a member of the Audit Committee and a member of the Compensation Committee of the Board. Mr. Wilber formerly served on the Company's Board of Directors from October 1997 through May 2000. Mr. Wilber is currently the President of Lynn's Hallmark Cards, which owns and operates a number of Hallmark Card stores. Mr. Wilber was a co-founder of Champs Sports Shops and served as its President from 1974 to 1984. He served on the Board of Royce Laboratories, a pharmaceutical concern, from 1990 until April 1997, when the company was sold to Watson Pharmaceuticals, Inc., a pharmaceutical concern. Robert A. Yanover has served as a director of the Company since January 1997 and is Chairman of the Audit Committee and a member of the Compensation Committee of the Board. Mr. Yanover founded Computer Leasing Corporation of Michigan, a private leasing company, in 1975 and has served as its President since that time. Mr. Yanover also founded Lason, Inc., a corporation specializing in the imaging business, and served as Chairman of the Board from its inception in 1987 until 1998 and as a director through February 2001. Each oÇcer serves at the discretion of the Board and holds oÇce until his or her successor is elected and qualiÑed or until his or her earliest resignation or removal. Messrs. LeRoy A. Vander Putten and Robert A. Yanover serve on the Board in the class whose term expires at the annual meeting of the stockholders (the ""Annual Meeting'') in 2005. Messrs. Marc D. Scherr, James A. FitzPatrick, Jr. and Rick A. Wilber serve on the Board in the class whose term expires at the Annual Meeting in 2006. Mr. Scott Scherr serves on the Board in the class whose term expires at the Annual Meeting in 2007. Code of Ethics The Company has adopted a Code of Ethics within the meaning of Item 406 of Regulation S-K of the Exchange Act. The Company's Code of Ethics applies to its principal executive oÇcer, principal Ñnancial oÇcer and principal accounting oÇcer. A copy of the Company's Code of Ethics is posted on the Company's website at www.ultimatesoftware.com. In the event that the Company makes any amendments to, or grants any waiver from, a provision of the Code of Ethics that requires disclosure under Item 5.05 of Form 8-K, the Company will post such information on its website. 61 Other Information The information set forth in the Company's Proxy Statement for the 2005 Annual Meeting of Stockholders under the headings ""Section 16(a) BeneÑcial Ownership Reporting Compliance'' and ""Board Meetings and Committees of the Board-Audit Committee'', is incorporated by reference. Item 11. Executive Compensation The information required by this item is incorporated by reference to the Company's Proxy Statement for the 2005 Annual Meeting of Stockholders under the heading ""Executive Compensation.'' Item 12. Security Ownership of Certain BeneÑcial Owners and Management and Related Stockholder Matters Equity Compensation Plan Information The following table summarizes the securities authorized for issuance under the Company's equity compensation plans as of December 31, 2004: ( a ) Number of Securities to be Issued upon Exercise of Outstanding Options, Warrants and Rights ( b ) Weighted Ó Average Exercise Price of Outstanding Options, Warrants and Rights ( c ) Number of Securities Remaining Available for Future Issuance under Equity Compensation Plans (Excluding Securities ReÖected in Column(a)) Plan Category Equity compensation plans approved by security holders ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 5,738,305 Total ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 5,738,305 $6.70 $6.70 2,405,525 2,405,525 The information set forth in the Company's Proxy Statement for the 2005 Annual Meeting of Stockholders under the heading ""Security Ownership of Certain BeneÑcial Owners and Management'' is incorporated by reference. Item 13. Certain Relationships and Related Transactions The information required by this item is incorporated by reference to the Company's Proxy Statement for the 2005 Annual Meeting of Stockholders under the heading ""Certain Related Transactions.'' Item 14. Principal Accountant Fees and Services The information required by this item is incorporated by reference to the Company's Proxy Statement for the 2005 Annual Meeting of Stockholders under the heading ""KPMG LLP Fees''. Item 15. Exhibits and Financial Statement Schedules Documents Ñled as part of this report: PART IV (1) Financial Statements. The following Ñnancial statements of the Company are included in Part II, Item 8, of this Annual Report on Form 10-K: Report of Independent Registered Public Accounting Firm Consolidated Balance Sheets as of December 31, 2004 and 2003 Consolidated Statements of Operations for the Years Ended December 31, 2004, 2003 and 2002 62 Consolidated Statements of Stockholders' Equity (DeÑcit) for the Years Ended Decem- ber 31, 2004, 2003 and 2002 Consolidated Statements of Cash Flows for the Years Ended December 31, 2004, 2003 and 2002 Notes to Consolidated Financial Statements (2) Consolidated Financial Statement Schedule: Report of Independent Registered Public Accounting Firm Schedule II Ì Valuation and Qualifying Accounts (3) Exhibits Number Description 3.1 Ì Amended and Restated CertiÑcate of Incorporation (incorporated by reference to Exhibit 3.4 to the Registration Statement on Form S-1 (File No. 333-47881), initially Ñled March 13, 1998 (the ""Registration Statement'') 3.2 Ì CertiÑcate of Designations of Series A Junior Preferred Stock (incorporated by reference to Exhibit 2 to the Company's Current Report on Form 8-K dated October 23, 1998) 3.3 Ì Amended and Restated Bylaws (incorporated herein by reference to Exhibit 3.5 to the Registration Statement) 4.1 Ì Form of CertiÑcate for the Common Stock, par value $0.01 per share** 4.2 Ì Form of Warrant for Common Stock (incorporated by reference to Exhibit 4.4 to the Company's Registration Statement on Form S-3 (File No. 333-107527), initially Ñled July 31, 2003 10.1 Ì Shareholders Rights Agreement, dated June 6, 1997 among the Company and certain stockholders named therein** 10.2 Ì Asset Purchase Agreement, dated February 2, 1998, among The Ultimate Software Group of Virginia, Inc., the Company and certain principals named therein** 10.3 Ì Asset Purchase Agreement, dated February 2, 1998, among the Company, The Ultimate Software Group of the Carolinas, Inc. and certain principals name therein** 10.4 Ì Asset Acquisition Agreement, dated February 20, 1998, among the Company, The Ultimate Software Group of Northern California, Inc. and certain principals named therein** 10.5 Ì Asset Purchase Agreement dated March 4, 1998, among the Company, Ultimate Investors Group, Inc. and certain principals name therein** 10.6 Ì Agreement and Plan of Merger dated February 24, 1998, among the Company, ULD Holding Corp., Ultimate Software Group of New York and New England, G.P. and certain principals named therein ** 10.7 Ì NonqualiÑed Stock Option Plan, as amended and restated as of December 20, 2002 (incorporated by reference to the corresponding exhibit in the Company's Annual Report on Form 10-K dated March 31, 2003) 10.8 Ì Commercial OÇce Lease agreement by and between UltiLand, Ltd., a Florida limited partnership, and the Company, dated December 31, 1998 (incorporated by reference herein to corresponding exhibit in the Company's Annual Report on Form 10-K dated March 31, 1999) 63 Number Description 10.9 Ì Rights Agreement, dated as of October 22, 1998, between the Company and BankBoston, N.A., as Rights Agent. The Rights Agreement includes the Form of CertiÑcate of Designations of Series A Junior Preferred Stock as Exhibit A, the Form of Rights CertiÑcate as Exhibit B, and the Summary of Rights as Exhibit C (incorporated by reference herein to Exhibit 2 to the Company's Current Report on Form 8-K dated October 23, 1998) 10.10 Ì Commercial OÇce Lease by and between UltiLand, Ltd., a Florida limited partnership and the Company, dated December 22, 1998 (incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q dated August 15, 1999) 10.11 Ì Letter Agreement between Aberdeen Strategic Capital LP and the Company, dated October 21, 1999 (incorporated herein by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q dated November 15, 1999) 10.12 Ì Warrant issued to Aberdeen Strategic Capital LP (incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q dated Novem- ber 15, 1999) 10.13 Ì Software License Agreement between the Company and Ceridian Corporation dated as of March 9, 2001 (incorporated by reference to Exhibit 10.17 to the Company's Annual Report on Form 10-K dated March 27, 2001) 10.14 Ì Letter amendment between the Company and Ceridian Corporation dated as of August 9, 2001 (incorporated by reference to Exhibit 10.14 to the Company's Annual Report on Form 10-K dated March 29, 2002) 10.15 Ì Letter amendment between the Company and Ceridian Corporation dated as of February 5, 2002 (incorporated by reference to Exhibit 10.15 to the Company's Annual Report on Form 10-K dated March 29, 2002) 10.16 Ì Loan and Security Agreement by and between the Company and Silicon Valley Bank dated as of November 29, 2001 (incorporated by reference to Exhibit 10.16 to the Company's Annual Report on Form 10-K dated March 29, 2002) 10.17 Ì Revolving Promissory Note by and between the Company and Silicon Valley Bank dated as of November 29, 2001 (incorporated by reference to Exhibit 10.17 to the Company's Annual Report on Form 10-K dated March 29, 2002) 10.18 Ì Equipment Term Note by and between the Company and Silicon Valley Bank dated as of November 29, 2001 (incorporated herein by reference to Exhibit 10.18 to the Company's Annual Report on Form 10-K dated March 29, 2002) 10.19 Ì Services Agreement between the Company and Ceridian Corporation dated as of February 10, 2003 (incorporated by reference to the corresponding exhibit in the Company's Annual Report on Form 10-K dated March 31, 2003) 10.20 Ì Third Loan ModiÑcation Agreement by and between the Company and Silicon Valley Bank dated March 27, 2003 (incorporated by reference to the correspond- ing exhibit in the Company's Annual Report on Form 10-K dated March 31, 2003) 10.21 Ì Fourth Loan ModiÑcation Agreement by and between the Company and Silicon Valley Bank dated as of April 29, 2003 (incorporated by reference to Ex- hibit 10.10 to the Company's Quarterly Report on Form 10-Q dated May 14, 2003) 10.22 Ì Change in Control Bonus Plan for Executive OÇcers, eÅective March 5, 2004 (incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q dated May 13, 2004) 10.23 Ì Fifth Loan ModiÑcation Agreement by and between the Company and Silicon Valley Bank dated as of May 28, 2004 (incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q dated August 12, 2004) 64 Number Description 10.24 Ì Silicon Valley Bank Second Amended and Restated Revolving Promissory Note by and between the Company and Silicon Valley Bank dated May 28, 2004 (incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q dated August 12, 2004) 21.1 Ì Subsidiary of the Registrant** 23.1 Ì Consent of Registered Public Accounting Firm* 31.1 Ì CertiÑcation Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended* 31.2 Ì CertiÑcation Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended* 32.1 Ì CertiÑcation Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002* 32.2 Ì CertiÑcation Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002* 99.1 Ì Cautionary Statement for Purposes of the ""Safe Harbor'' Provisions of the Private Securities Litigation Reform Act of 1995* * Filed herewith. ** Incorporated by reference to the corresponding exhibit in the Company's Registration Statement. 65 Report of Independent Registered Public Accounting Firm The Board of Directors The Ultimate Software Group, Inc.: Under date of March 10, 2005, we reported on the consolidated balance sheets of The Ultimate Software Group, Inc. and subsidiary as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders' equity (deÑcit), and cash Öows for each of the years in the three-year period ended December 31, 2004, which reports appear in the December 31, 2004, Annual Report on Form 10-K. In connection with our audits of the aforementioned consolidated Ñnancial statements, we also audited the related consolidated Ñnancial statement schedule as listed in Item 15 of this 10-K. This Ñnancial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion on this Ñnancial statement schedule based on our audits. In our opinion, such Ñnancial statement schedule, when considered in relation to the basic consolidated Ñnancial statements taken as a whole, present fairly, in all material respects, the information set forth therein. Miami, Florida March 10, 2005 /s/ KPMG LLP KPMG LLP 66 SCHEDULE II THE ULTIMATE SOFTWARE GROUP, INC. AND SUBSIDIARY VALUATION AND QUALIFYING ACCOUNTS ClassiÑcation Allowance for doubtful accounts: Balance at Beginning of Year Charged to Write-oÅs Expenses and Other and Other Balance at End of Year December 31, 2004 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ December 31, 2003 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ December 31, 2002 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $ 525 1,000 2,465 $ 419 213 1,657 $ (444) (688) (3,122) $ 500 525 1,000 Valuation allowance for deferred tax asset: December 31, 2004 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ December 31, 2003 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ December 31, 2002 ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $27,959 24,233 18,461 $3,218 3,726 5,772 $ Ì Ì Ì $31,177 27,959 24,233 67 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SIGNATURES THE ULTIMATE SOFTWARE GROUP, INC. By: /s/ Mitchell K. Dauerman Mitchell K. Dauerman Executive Vice President, Chief Financial OÇcer and Treasurer Date: March 10, 2005 Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date /s/ Scott Scherr Scott Scherr /s/ Mitchell K. Dauerman Mitchell K. Dauerman /s/ Marc D. Scherr Marc D. Scherr James A. FitzPatrick, Jr. /s/ James A. FitzPatrick, Jr. /s/ LeRoy A. Vander Putten LeRoy A. Vander Putten /s/ Rick Wilber Rick Wilber /s/ Robert A. Yanover Robert A. Yanover President, Chief Executive OÇcer and Chairman of the Board March 10, 2005 Executive Vice President, Chief Financial OÇcer and Treasurer (Principal Financial and Accounting OÇcer) March 10, 2005 Vice Chairman of the Board and Chief Operating OÇcer March 10, 2005 Director March 10, 2005 Director March 10, 2005 Director March 10, 2005 Director March 10, 2005 68 Exhibit 31.1 I, Scott Scherr, certify that: CERTIFICATIONS 1. I have reviewed this annual report on Form 10-K of The Ultimate Software Group, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the Ñnancial statements, and other Ñnancial information included in this annual report, fairly present in all material respects the Ñnancial condition, results of operations and cash Öows of the Registrant as of, and for, the periods presented in this annual report; 4. The Registrant's other certifying oÇcer and I are responsible for establishing and maintaining disclosure controls and procedures (as deÑned in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over Ñnancial reporting (as deÑned in Exchange Act Rules 13a-15(f) and 15d-15(f) for the Registrant and have: a) Designed such disclosure controls and procedures or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) Designed such internal control over Ñnancial reporting, or caused such internal control over Ñnancial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of Ñnancial reporting and the preparation of Ñnancial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the eÅectiveness of the Registrant's disclosure controls and procedures and presented in this report our conclusions about the eÅectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the Registrant's internal control over Ñnancial reporting that occurred during the Registrant's most recent Ñscal quarter (the Registrant's fourth Ñscal quarter in the case of an annual report) that has materially aÅected, or is reasonably likely to materially aÅect, the Registrant's internal control over Ñnancial reporting; and 5. The Registrant's other certifying oÇcer and I have disclosed, based on our most recent evaluation of internal control over Ñnancial reporting, to the Registrant's auditors and the audit committee of the Registrant's board of directors (or persons performing the equivalent functions): a) All signiÑcant deÑciencies and material weaknesses in the design or operation of internal control over Ñnancial reporting which are reasonably likely to adversely aÅect the Registrant's ability to record, process, summarize and report Ñnancial information; and b) Any fraud, whether or not material, that involves management or other employees who have a signiÑcant role in the Registrant's internal control over Ñnancial reporting. /s/ Scott Scherr Scott Scherr Chief Executive OÇcer Date: March 10, 2005 (This page intentionally left blank) Exhibit 31.1 I, Scott Scherr, certify that: CERTIFICATIONS 1. I have reviewed this annual report on Form 10-K of The Ultimate Software Group, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the Ñnancial statements, and other Ñnancial information included in this annual report, fairly present in all material respects the Ñnancial condition, results of operations and cash Öows of the Registrant as of, and for, the periods presented in this annual report; 4. The Registrant's other certifying oÇcer and I are responsible for establishing and maintaining disclosure controls and procedures (as deÑned in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over Ñnancial reporting (as deÑned in Exchange Act Rules 13a-15(f) and 15d-15(f) for the Registrant and have: a) Designed such disclosure controls and procedures or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) Designed such internal control over Ñnancial reporting, or caused such internal control over Ñnancial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of Ñnancial reporting and the preparation of Ñnancial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the eÅectiveness of the Registrant's disclosure controls and procedures and presented in this report our conclusions about the eÅectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the Registrant's internal control over Ñnancial reporting that occurred during the Registrant's most recent Ñscal quarter (the Registrant's fourth Ñscal quarter in the case of an annual report) that has materially aÅected, or is reasonably likely to materially aÅect, the Registrant's internal control over Ñnancial reporting; and 5. The Registrant's other certifying oÇcer and I have disclosed, based on our most recent evaluation of internal control over Ñnancial reporting, to the Registrant's auditors and the audit committee of the Registrant's board of directors (or persons performing the equivalent functions): a) All signiÑcant deÑciencies and material weaknesses in the design or operation of internal control over Ñnancial reporting which are reasonably likely to adversely aÅect the Registrant's ability to record, process, summarize and report Ñnancial information; and b) Any fraud, whether or not material, that involves management or other employees who have a signiÑcant role in the Registrant's internal control over Ñnancial reporting. /s/ Scott Scherr Scott Scherr Chief Executive OÇcer Date: March 10, 2005 (This page intentionally left blank) Exhibit 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 I, Scott Scherr, Chief Executive OÇcer of The Ultimate Software Group, Inc., hereby certify to the best of my knowledge and belief that this Annual Report on Form 10-K fully complies with the requirements of Section 13(a) or 15(d) of the Securities and Exchange Act of 1934 (15 U.S.C. 78m(a) or 78o(d)) and that the information contained in this Annual Report on Form 10-K fairly represents, in all material respects, the Ñnancial condition and results of operations of The Ultimate Software Group, Inc. /s/ Scott Scherr Scott Scherr Chief Executive OÇcer Date: March 10, 2005 (This page intentionally left blank) Exhibit 32.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 I, Mitchell K. Dauerman, Chief Financial OÇcer of The Ultimate Software Group, Inc., hereby certify to the best of my knowledge and belief that this Annual Report on Form 10-K fully complies with the requirements of Section 13(a) or 15(d) of the Securities and Exchange Act of 1934 (15 U.S.C. 78m(a) or 78o(d)) and that the information contained in this Annual Report on Form 10-K fairly represents, in all material respects, the Ñnancial condition and results of operations of The Ultimate Software Group, Inc. /s/ Mitchell K. Dauerman Mitchell K. Dauerman Chief Financial OÇcer (Principal Financial and Accounting OÇcer) Date: March 10, 2005 (This page intentionally left blank) operating data in thousands, except per share data for the years ended december 31, 2 0 0 4 2 0 0 3 2 0 0 2 net loss $(5,024) $(9,169) $(14,568) diluted net loss per share (1) $(0.23) $(0.49) $(0.90) (1) See Note 2 of the Notes to Consolidated Financial Statements included elsewhere in this Annual Report for information regarding the computation of diluted net loss per share. $39,049 24,924 8,055 $29,344 23,478 7,594 $19,345 23,634 12,170 72,028 60,416 55,149 40,626 56% 45,650 63% 32,837 54% 42,006 70% 27,621 50% 42,189 77% 10,544 52,546 28,476 – – 35,812 31,143 24,610 27,815 1,231 796 1,206 selected financial data revenues: recurring services license total revenues gross margin as a % of total revenues operating expenses and other as a % of total revenues investments in marketable securities total assets deferred revenue long-term debt, including capital lease obligations, net of current portion company profile board of directors Scott Scherr Chairman, President, and Chief Executive Officer Ultimate Software Marc D. Scherr Vice Chairman and Chief Operating Officer Ultimate Software James A. FitzPatrick, Jr. Partner Dewey Ballantine LLP executive officers Scott Scherr Chairman, President, and Chief Executive Officer Marc D. Scherr Vice Chairman and Chief Operating Officer LeRoy A. Vander Putten Executive Chairman The Insurance Center, Inc. Robert A. Yanover President Computer Leasing Corporation Rick A. Wilber President Lynn’s Hallmark Cards Mitchell K. Dauerman Executive Vice President, Chief Financial Officer, and Treasurer balance sheet data in thousands as of december 31, 2 0 0 4 2 0 0 3 2 0 0 2 annual meeting cash and cash equivalents $14,766 $13,783 $8,974 The annual meeting of stockholders will be held on Tuesday, May 17, 2005, at 10:00 a.m. EDT at 2000 Ultimate Way, Weston, Florida. Formal notice will be sent to stockholders of record as of March 18, 2005. stockholders’ equity (deficit) $13,524 $1,661 $(7,368) Ultimate Software, a leading provider of Web-based payroll and workforce management solutions, markets award-winning UltiPro as licensed software, as a hosted application through Intersourcing, and as a co-branded offering to Business Service Providers (BSPs) under the “Powered by UltiPro” brand. The Company employs approximately 450 professionals who are united in their commitment to developing trendsetting solutions and delivering quality service. Ultimate Software customers represent diverse industries and include such organizations as Benihana Restaurants, The Container Store, Elizabeth Arden, Omni Hotels, Ruth’s Chris Steak House, SkyWest Airlines, and Trammell Crow Residential. More information on Ultimate Software’s products and services can be found at www.ultimatesoftware.com. UltiPro and Intersourcing are registered trademarks of The Ultimate Software Group, Inc. All other trademarks referenced in this report are the property of their respective owners. annual report and form 10-K A copy of the Company’s 2004 Form 10-K filed with the Securities and Exchange Commission, which is provided in this Annual Report, is available without charge upon request to: Investor Relations Department, 2000 Ultimate Way, Weston, Florida 33326. independent registered public accounting firm investor relations KPMG LLP Miami, Florida legal counsel Dewey Ballantine LLP New York, New York transfer agent and registrar EquiServe Trust Company, N.A. P.O. Box 219045 Kansas City, MO 64121-9045 877.282.1168 www.equiserve.com For additional information about Ultimate Software, contact Mitchell K. Dauerman, 954.331.7369 stock trading Ultimate Software’s common stock is traded on the Nasdaq National Market under the symbol ULTI. company address Ultimate Software 2000 Ultimate Way Weston, Florida 33326 800.432.1729 or 954.331.7000 www.ultimatesoftware.com Ultimate Software 2000 Ultimate Way Weston, Florida 33326 800.432.1729 954.331.7000 www.ultimatesoftware.com
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